Restaurants can reduce the federal taxes they owe by claiming a credit for FICA taxes they pay on tips reported by employees. Here’s how.
Restaurants that employ workers who earn tips have some extra work to do when it comes to paying the employer portion of FICA taxes due on those tips. The good news is that the law provides a benefit to employers in this situation. Restaurants can claim a credit against their federal income tax based on the share of FICA and Medicare taxes they pay on tip income that employees report.
A quick refresher on why employers owe FICA tax on tips
If you’re already familiar with why restaurants pay FICA taxes on income they didn’t actually pay to employees, skip ahead to the next section. If not, here’s a quick refresher on the process:
Customers pay tips to waitstaff, bartenders, etc.
Employees who get more than $20 in tips in a month are required to report the amount of tips they received to their employer at least once a month.
When employees get their paycheck for hourly wages, employers withhold income and FICA taxes.
Employers of tipped employees must also withhold the employee’s share of FICA taxes due on the tip income reported.
Those same employers then remit the withholdings to the government, and they’re required to add the employers’ matching share of FICA taxes owed based on the total of each employee’s wages and tips.
In an ideal system, the employer portion of FICA taxes due on tip income would somehow be paid by those who leave the tips because they’re the ones actually compensating the server for the work. Since there’s no reasonable way to make that happen, the law assigns responsibility for the employer portion of FICA tax on tip income to the restaurant owner.
The credit reduces the restaurant’s federal tax by an amount based on the employer’s share of FICA taxes paid on a portion of reported tips.
What is the FICA tip credit?
The FICA tip credit gives some relief to employers who pay FICA taxes on tip income that was paid to their employees by someone else. The credit reduces the federal income tax of the employer by an amount based on the employer’s share of FICA taxes paid on a portion-reported tips.
The calculation is not quite as easy as just multiplying reported tips by the FICA percentage. Taxes are reduced based on an amount known as creditable tips. Tipped employees are usually paid a much lower hourly rate than nontipped employees, and that rate typically falls well below the federal minimum wage. To determine creditable tips:
Multiply the number of hours the employee worked times $5.15 (the federal minimum wage rate in 2007 when the credit was enacted) to determine the federal minimum wage amount for the employee.
Subtract from that number the actual wages paid to the employee to arrive at the amount of tips not eligible for the credit.
Subtract the amount of tips not eligible from the total tips reported by the employee to determine the amount of creditable tips.
Multiply the creditable tip amount by the FICA tax rate, currently 7.65 percent, to determine the amount of credit available.
A few caveats and conditions
1. To qualify as a “tip,” the payment from the customer to the employee must meet four conditions:
- A customer can’t be compelled to pay it.
- The customer must have the unrestricted right to determine the amount.
- The payment can’t be subject to negotiation or dictated by employer policy.
- The customer must have the right to determine who receives the payment.
For instance, a service charge applied to a bill for large parties or catering events that’s then shared among the servers will generally not qualify as a tip that can be included in the creditable tip calculation.
To qualify as a “tip,” the payment from customer to employee must meet four conditions. For instance, a customer can’t be compelled to pay it.
2. The FICA tip credit is included on the employer’s tax return as part of the General Business Tax Credit (GBTC). The GBTC is not a refundable credit, so it can’t reduce a tax liability below $0. Unused portions of the credit can be carried forward to future years.
3. The expense that a taxpayer claims for employer FICA taxes must be reduced by the amount of FICA tip credit claimed in that year.
4. Certain large food or beverage establishments (U.S. restaurants that employ 10 or more servers on a typical day and serve meals on-premises) are required to report to the IRS the total amount of tips that employees reported to them. If that number fails to exceed 8 percent of an establishment’s gross food and beverage receipts, the IRS will deem that employees have underreported their tips and require a recalculation of tip income for some employees. Such a recalculation would also have an effect on the employer’s FICA tip credit for the year.
Conditions and caveats like these can add complexity to what might otherwise seem like a straightforward calculation. If you’d like more information about qualifying for or calculating the FICA tip credit, or any other issues affecting the food service industry, please contact us.