If you are a restaurant owner and you have employees that receive tips from customers on a regular basis, you may be eligible for a favorable federal tax credit. The “Credit for Employer Social Security and Medicare Taxes,” better known as the “FICA Tip Credit,” is a tax credit equal to the Social Security and Medicare taxes paid by an employer on certain employees’ tips earned working in a restaurant.
What is a tip?
According to Internal Revenue Service Revenue Ruling 2012-18, tips earned by servers in a restaurant are defined as:
- Payments made free from compulsion
- A payment the customer has unrestricted rights to determine the amount
- Payments not the subject of negotiation or dictated by employer policy
- A payment the customer has the right to determine who the recipient is
As an employer, what am I required to do with the tips collected?
When tips or gratuities are collected, employers are required to distribute the funds directly to the employees who earned them. Tips that are distributed are considered compensation to the employee and require the employer to withhold 4.2% for Social Security taxes and 1.45% for Medicare taxes. The employer is also required to pay their share of the employment taxes, which is equal to 7.65% (6.2% Social Security and 1.45% Medicare) of the total compensation paid out to employees.
If employees receive tips from customers directly, the employees are required to furnish a report to the employer disclosing the total tips received in a given month. Employees can use Form 4070 “Employee’s Report of Tips to Employer” to disclose the amount of tips received.
Withholding employment taxes from the tips collected is a requirement that needs to be taken seriously. The IRS is cracking down to make sure that all restaurant owners are both withholding employment taxes and reporting all tips distributed to the servers as employee compensation.
How is the tax credit calculated?
The employer’s share of the employment taxes on the tips disbursed to the employees would be the amount of the “FICA Tip Credit” the employer can claim on Tax Form 8846 ‘Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips.’ However, if your tipped employees are paid less than minimum wage, the credit is reduced by the employment taxes the employer would have paid on the difference.
Example: Café Burger is a sit-down restaurant where there are employees hired to serve food and beverages. In 2012, the restaurant collects $200,000 in gratuities that were distributed to the employees, all of whom were paid minimum wage. The restaurant withholds both Social Security and Medicare Taxes from the employees’ gratuities that were distributed as compensation and pays their 7.65% or $15,300 share of the employment taxes. Café Burger’s “FICA Tip Credit” is equal to the $15,300 that they paid on the employees’ tips.
Where does the tax credit go on my corporate tax return?
Restaurant owners who are incorporated as C-corporations would use the credit to directly reduce the tax liability on the face of the tax return. S-corporations and partnerships would pass the credit to its shareholders or members via their respective K-1 schedules. The shareholders or members would then claim their share of the tax credit on their personal income tax returns.
What type of payments received do not qualify for the tax credit?
All restaurant owners wanting to claim the “FICA Tip Credit” should be aware that the following payments received by employees are not considered tips eligible for the tax credit:
- Tips that are used to meet the federal minimum wage
- Distributed service charges to employees
Service charges are mandatory adds-ons to a food or beverage bill. An example of a service charge is an automatic 18% charge added the bill for parties of 8 or more. Internal Revenue Service Revenue Ruling 2012-18 explains that the service charges received by a restaurant are deemed as business income to the restaurant as opposed to employees. Any amounts distributed to the employees are treated as regular wages and are not eligible for the tip credit.
Please call your Aronson tax advisor or Aaron Boker at 301.231.6200 if you have any questions regarding this tax credit or other tax items related to your restaurant business.