tip tax credit
Beginning in 2014, the IRS is changing the way restaurants treat service charges they add to customers’ bills. A service charge is usually a
required tip amount that restaurants add to the bill of large parties. For example, a restaurant may add a 18% required tip to a bill of a party of 10 or more people.
Restaurants are currently treating service charges as tips and not as wages. By doing this, they are leaving it up to the employee to report the service charges as income (i.e., some of these service charges may go unreported by employees). Restaurants are also claiming the tip tax credit on the amount of FICA taxes they are paying on service charges. The tip tax credit can be a substantial tax benefit for restaurants.
The IRS issued new guidance in 2012 that is taking effect January 1, 2014 that will require restaurants to treat service charges as wages, and not as tips. By doing this, restaurants will be required to track the service charges paid to employees (and not rely on the employee reporting the service charges as tips). Restaurants will also have to withhold taxes from the service charges.
Additionally, treating the service charges as wages will affect the hourly wage earned by employees. Finally, since the service charges are classified as wages, the FICA taxes paid on service charges will no longer qualify for the tip tax credit.
There is a way to avoid service charge treatment. To be classified as a tip, and not as a service charge:
- the payment must be made free from compulsion
- the customer must have the unrestricted right to determine the amount
- the payment should not be the subject of negotiation or dictated by employer policy; AND
- generally, the customer has the right to determine who receives the payment.
Example: Euro Restaurant automatically adds an 18% gratuity to bills of parties of 10 or more. On the bill, the tip line is automatically filled in with an amount equal to 18% of the food and beverage charge. Euro Restaurant distributes the service charge to its wait staff and bussers. The service charge will be treated as wages because: the payment was made under compulsion because it was required, the customer did not have the right to determine the amount, the payment was dictated by employer policy, and the customer did not have the right to determine who would receive the tip.
A technique some restaurants are using to avoid the service charge treatment is to suggest (and not require) tip amounts.
Example: Asia Restaurant does not require a service charge to bills of large parties, but they do suggest either a 15%, 18%, or 20% tip amount. The tip amount at each percentage level is listed on the bill. Customers are free to use any of the suggested tips, tip based on their own rate, or not tip at all. Under these circumstances, any amount the customers fill in the tip line will be treated as tips and not as wages. This is because: the payment was not made under compulsion—the restaurant only suggested a tip amount. The customer was free to determine what amount would be tipped. The payment was not dictated by restaurant policy.
It is expected that most restaurants who charge a required service charge will stop doing so and instead only suggest tip amounts.
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There is a tax credit available to restaurants that have tipped employees. The credit is based on the FICA taxes paid by the restaurant on reported tips. Although this credit has been available to restaurants for years, many tax professionals fail to inform their clients that the credit is available. If you’re a restaurant owner, keep reading.
Restaurants must pay FICA taxes on any tips reported by tipped employees. This requirement has been criticized by the restaurant industry since 1987 because reported tips in excess of the minimum wage are not counted as wages under the Fair Labor Standards Act (FLSA). Since tips in excess of minimum wage are not counted as wages under the FLSA, it is argued that it is not appropriate to require restaurants to pay FICA taxes on these tips.
As a result of lobbying by the restaurant industry, Congress created a tax credit in 1993 to offset some of the FICA taxes paid by restaurants on excess tips (tips that get the employee over minimum wage). The credit is named the Credit for Portion of Employer Social Security Paid with Respect to Employee Cash Tips. They tried, but couldn’t come up with a longer name.
How it Works
The credit is calculated as 7.65% of tips in excess of the federal minimum wage. For purposes of this tax credit, the federal minimum wage is capped at $5.15, and not at the normal $7.25 federal minimum wage. Michigan’s minimum wage of $7.40 is not relevant to this credit; however, under Michigan law the employee’s base wage plus tips must be at least $7.40.
Example: JoJo’s Restaurant has a tipped employee who earns $2.65 per hour. The employee worked 1,500 hours during 2012 and had tips of $8,000.
The tip tax credit is calculated as follows:
Hourly Tip Rate: $5.33 ($8,000 tips divided by 1,500 hours)
Tips Deemed Wages: $2.50 ($5.15 federal minimum wage less $2.65 wage)
Excess Tips per Hour: $2.83 ($5.33 total tips less $2.50 tips treated as wages)
Total Excess Tips: $4,245 ($2.83 excess tips per hour times 1,500 hours worked)
Tip Tax Credit $325 ($4,245 times 7.65% FICA rate)
The tip tax credit for this single employee is $325.
The tip tax credit is calculated for each individual employee. Modern payroll software makes it much easier to determine how much of each employee’s tips are deemed wages and how much are excess tips.
There has been some confusion as to whether restaurant owners could claim the credit on unreported tips discovered during an IRS audit. The answer is yes—restaurant owners can claim the tip tax credit on unreported tips discovered during an audit (good news if you’re looking for a silver lining during an audit.)
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230