Employees in traditionally tipped positions typically rely on tips to supplement their wages paid by their employers. For many, including those in the food and beverages industries, tips constitute a significant portion of their earnings. As an employer, if you are planning to take a tip credit as an allowance against your minimum wage obligation you must accurately calculate employee wages and understand how tip credits impact this requirement.
If you have employees who earn $30 or more in tips per month as part of their regular wages.
Employers are reminded that they must comply with applicable federal and state laws and regulations related to tip credits. As addressed more fully below, some jurisdictions do not permit an employer to take a tip credit.
What is a Tip Credit?
Tip credits are a way to include gratuities in minimum wage calculations. They allow an employer to credit a portion of an employee's tips toward the employer's obligation to pay minimum wage. Tip credits are not deducted from employees' pay; instead, if permitted to take a tip credit employers may claim a certain amount against their minimum wage requirement.
Who Do Tip Credits Apply to?
Tip credits can only be applied to a tipped employee — defined as an employee who regularly earns at least $30 per month in tips — and can only be applied to hours of work that produce tips or directly support tip-producing work as long as the directly supporting work is not performed for a substantial amount of time. A substantial amount of time is defined as more than 20 percent of the hours worked during the employee’s workweek for which the employer has taken a tip credit or a continuous period that exceeds 30 minutes.
This change was included in the U.S. Department of Labor, Wage and Hour Division, Final Rule titled “Tip Regulations Under the Fair Labor Standards Act (FLSA), Partial Withdrawal” that takes effect Dec. 28, 2021.
Tips can come directly from customers, or as part of a tip pool. If taking a tip credit, the tips earned by the employee must equal at least the difference between the cash wage and minimum wage for the jurisdiction in which the employee works. Employers are required to make up the difference if an employee’s combined wages and tips do not reach minimum wage levels.
Non-tipped workers don't qualify for an employer to take a tip credit, and employers must pay these non-exempt employees at least minimum wage for all hours worked.
How Does a Tip Credit Work?
With tip credits, an employer can credit a portion of an employee's tips toward the employer obligation to pay minimum wage.
As background, the Fair Labor Standards Act (FLSA) is a federal law that generally requires employers to pay employees at least the federal minimum wage, which is currently $7.25 per hour. The FLSA allows employers of certain employees to count a limited amount of the tips that its tipped employees receive as a credit toward this federal minimum wage obligation. Employers may satisfy the federal minimum wage by paying a base hourly rate (a minimum of $2.13) and accounting for the remainder ($5.12) through the value of tips an employee receives. The employer must notify employees that their tips are being credited toward the minimum wage and employees must be able to retain all tips that they receive. Notice requirements are reviewed in DOL Fact Sheet #15.
Additionally, tipped employees are typically classified as non-exempt employees, which means FLSA standards such as overtime pay that apply to other non-exempt employees also apply to tipped employees. For example, if a tipped employee works more than 40 hours in a work week, the employer must pay overtime wages in accordance with applicable wage and hour laws.
State Laws on Tip Credit
While the FLSA requires that employers pay employees at least the federal minimum wage, state laws may differ. This is because many states have a higher minimum wage than the federal $7.25 per hour. Additionally, Alaska, California, Minnesota, Montana, Nevada, Oregon, and Washington do not allow employers of tipped employees to take a tip credit. Several states currently allow a tip credit, but require a higher direct or cash minimum wage be paid to employees. Other states may define tipped employee or when a tip credit may be taken differently than the FLSA. For these reasons, it's important that employers refer to the U.S. Department of Labor (DOL) website and/or the state website where employees are working for more information and applicable guidance on tip credit.
FICA Tip Tax Credit
As with any employer, food and beverage industries need to understand their responsibilities as they pertain to Federal Insurance Contribution Act (FICA) taxes. As part of this, accurately reporting the tips that workers receive may give restaurant employers access to another potentially valuable tax credit, known as the FICA tip tax credit.
What is the FICA Tip Credit?
Employers with employees who earn gratuities are required to pay taxes on the tips their employees collect from patrons, as the tips are considered income under FICA. But restaurant employers may receive an incentive for accurately reporting their workers' tip earnings: an income tax credit called the FICA tip credit, which can potentially save restaurants hundreds of dollars per employee.
The FLSA allows restaurant employers to include the tips their employees earn toward meeting the minimum wage requirements. If the amount of tips exceeds the federal minimum requirement, restaurant employers may be eligible for a partial tax credit. This credit equals the employer's portion of the FICA tax, which is currently 7.65 percent, multiplied by the tips in excess of the federal minimum wage. With respect to FICA, tips are defined as income.
Who Does it Apply to?
The FICA tip tax credit is only available to employers in the food and beverage industry that have a tipped workforce. Businesses in other industries are not eligible to claim this credit.
To be eligible for the credit, restaurants must determine that all non-exempt employees are compensated at least the federal minimum wage for hours worked. If the state where the restaurant resides has a higher minimum wage rate, the higher wage applies. Compensation may be totaled from different types of compensation received, such as hourly wages, tips, and gratuities that the staff member records, and meals that the restaurant provides to the employee.
Employees must keep an accurate record of daily tips, whether they come in the form of cash or credit. A total must be provided on an annual basis to the employer. This reported total is then used as the basis of income tax recording, Social Security payments, and other withholdings. Restaurants must follow up with employees as required to ensure this information is received.
How Do You Calculate the FICA Tip Tax Credit?
A FICA tip credit calculator can help you estimate how much of a tax credit you may receive. Here's an example of calculating FICA tip credit:
Sarah works at a restaurant. She earns $2.13 an hour, works 30 hours a week, and reports $250 in tips in a given week. Although the federal minimum wage has since been raised to $7.25 an hour, the FICA tip credit will continue to be based on the old minimum wage of $5.15 an hour, due to the Small Business and Work Opportunity Tax Act of 2007.
To determine Sarah's weekly wages, multiply her hourly wage by hours worked weekly:
$2.13 × 30 = $63.90
Add in her weekly reported tips:
$250.00 + $63.90 = $313.90
Next, calculate the wages paid at minimum wage by multiplying the minimum hourly wage rate ($5.15) by 30 hours worked:
$5.15 × 30 = $154.50
Subtract the first value ($313.90) by the second value ($154.50) to find the amount of tips in excess of minimum wage:
$313.90 — $154.50 = $159.40
Multiply that number by the employer's portion of the FICA tax to determine the tax credit:
$159.40 × 7.65% = $12.19
While that may not seem like a lot of money, if Sarah consistently works the same amount of hours and earns the same amount of tips for 52 weeks, the potential annual savings could be $633.88. And the more tipped employees you have, the more savings you can earn.
While employers are generally prohibited from retaining any part of an employee's tips, they can organize a tip-pooling arrangement for tipped employees. In this setup, a portion or all of the tip money from the shift is collected and redistributed amongst the tip-earning staff, and may benefit employers when there is a significant disparity between key positions in the daily operations of the restaurant.
In relation to the FICA tip tax credit, a tip pool could affect how much of a credit you are eligible to claim. However, a tip-pooling arrangement could help offset the minimum wage requirement for employees who may not otherwise receive enough in tips to make up the difference.
Employers should be aware of various federal developments around tip pooling in recent years. In 2020, the DOL published a final rule that:
- Eliminated the 80/20 Rule and allowed an employer to use tip credit for time a tipped employee performs non-tipped duties that are either “contemporaneously with or for a reasonable time immediately before or after” performing tipped duties
- Prohibited employers from keeping tips received by employees
- Prohibited managers and supervisors from participating in tip pools
In a subsequent final rule, the DOL clarified that while managers or supervisors may not receive tips from mandatory tip pools, managers and supervisors are not prohibited from contributing tips to eligible employees in such pools.
Congress also amended the FLSA as part of the Consolidated Appropriations Act (CAA) of 2018. The CAA prohibits an employer from keeping tips received by its employees for any purposes, including allowing managers or supervisors to keep employees' tips, regardless of whether the employer takes a tip credit.
Businesses in industries where employees are tipped face intricacies in payroll and taxes, as well as requirements to accurately report their workers' tip earnings. Fortunately, there are incentives in the form of tax credits that may be available. Consider working with a trusted and reputable payroll provider to help you through every step of the process.