Payroll can be a unique challenge for businesses that employ tipped workers. Complex regulations that change from federal to state and local levels make handling payroll for tipped employees a complicated undertaking for many small businesses.
By understanding government regulations concerning tipped employees, employers can take appropriate steps to reduce risk and ensure compliance.
Minimum Wage For Tipped Employees
Federal law determines the minimum wage rate at which employees can be paid. Although individual states set their own minimum wage rate, unless the state rate is higher, employers must pay their employees based on the federal minimum wage. This is true for tipped employees as well. Since July 24, 2009, the federal minimum wage rate has been set at $7.25 per hour.
However, federal law also permits employers to count employee tips as part of their wages by taking a credit against the minimum wage requirement. The maximum amount of credit that the employer can apply is $5.12 per hour resulting in a tipped employee federal minimum wage of $2.13 per hour when the maximum credit is applied.
This credit applies only to tipped employees, and many states have regulations concerning these credits. The Wage and Hour Division of the U.S. Department of Labor (DOL) maintains a table of minimum hourly wages for tipped employees, segmented by state. Although employers can take advantage of the tip credit, the employer is still obligated to ensure that an employee’s combined total of wages and tips meets or exceeds minimum wage.
In states where the minimum wage is higher than $7.25, employers must be sure employees are receiving the equivalent of the state minimum. If an employee’s tips do not bring his or her total wages up to the minimum, the employer must pay the difference to the employee. The DOL provides a list of state minimum wage rates.
Overtime For Tipped Employees
When an employer takes advantage of the tip credit, there is a special overtime rule that needs to be applied when calculating the overtime rate. For any overtime hours worked the maximum tip credit remains the same. In other words, the employer can take a tip credit of no more than $5.12, regardless of how many hours the employee worked. The calculation for overtime rate for an employee paid at the federal minimum wage when the maximum federal tip credit is applied is:
$7.250 federal minimum wage
3.625 plus 1/2 federal minimumwage equals
$10.875 hourly overtime rate
<5.120> less maximum federal tip credit equals
$5.755 overtime rate for tipped employees being paid federal minimum wage when the maximum federal tip credit is applied.
Tip Credit Notice Requirement
- A tip credit regulation under the Fair Labor Standards Act requires employers to provide oral or written notice to each employee that the employer is taking the tip credit and how the employee’s tips will be applied to their wages. Notification must include the following:
- The hourly rate the employer is paying the tipped employee (at least $2.13/hour) The amount the employer is claiming as a tip credit (not more than $5.12/hour)
- A statement that the tip credit cannot exceed the actual tips received by the employee
- An explanation that all tips received by the tipped employee remain the property of the tipped employee (except in a valid pooling arrangement. However, pooled tips are to be distributed only among eligible employees; the employer may not receive any of the employees’ pooled tips.)
- A notation that the tip credit will not be applied to any employees’ wages unless the employee has been notified of the tip credit provisions.
If an employer fails to notify the worker, use of the tip credit is prohibited and the employer must pay the employee at least minimum wage and allow the employee to retain all tips. Should the employer not inform the employee and take the tip credit, the business is subject to criminal and civil penalties from the DOL in addition to any lawsuit the employee may file.
Tips vs. Service Charges
Beginning in January 2014, IRS Rev. Rul. 2012-18 classifies service charges (sometimes referred to as automatic gratuities) as regular wages rather than allowing them to be considered tips. As a result, employers will need to include service charges in employee wages and must withhold payroll taxes from that income.
In general, service charges are mandatory fees charged by the establishment for which the customer does not have the ability to control the amount or the right to determine who receives the money. It often appears as a line item on the customer’s bill. For example, an automatic 15% gratuity added to a party of six or more at a restaurant is considered a service charge. The distribution of a service charge is up to the employer; all or part of the charge may be paid to someone other than the server.
On the other hand, a tip is a non-compulsory amount determined by the customer and given to an employee of the establishment in recognition of service received. Tips are not negotiated by or determined by the employer, but rather are solely between the customer and server, and tips belong to the employee, not the employer.
In some establishments, employees who regularly and customarily receive tips are required to contribute a portion of their tips to a pool, which is then divided among a group of employees. Employees may only contribute any amount in tips received that are in excess of minimum wage when combined with their hourly wage. Tips from a pool cannot go to employees, like chefs and dishwashers, who don’t usually receive tips. Employers, and in some states managers or supervisors, are prohibited from receiving funds from pooled tips.
Employees receiving more than $20.00 per month in tips must report the total amount of their tips to the employer by the 10th day of the following month. The IRS provides Form 4070, Employee’s Report of Tips to Employer for this purpose, although employees may use anything similar to complete this reporting. The report must include the employee’s name, address, Social Security number, employer’s name and address, the period that the report covers and the total tips received.
Tips reported must include both amounts received directly by the employee and charged tips paid over to the employee. Generally, employees report their tips to their employer at the end of each night on paper or through the restaurant management software. Additional information about tip withholding and reporting, including W-2s, tip allocation and voluntary compliance programs are available on the IRS website.
Tips In Excess Of Minimum Wage
Businesses that employ workers who receive tips for providing, delivering or serving food or beverages for consumption and incurred the employer’s portion of Social Security and Medicare taxes (FICA) on those tips may be entitled to a tax credit. Known as the Section 45B credit, this credit is for the employer’s share of FICA taxes paid on tips reported in excess of minimum wage. It is important to keep in mind that this credit is applicable only to tips collected by food and beverage employees.
The credit is part of the general business tax credit and is claimed on IRS Form 8846, Credit for Employer Social Security and Medicare Taxes on Certain Employee Tips.
The IRS is very specific about the treatment of the Section 45B credit. Additional information regarding the Section 45B credit, including how to claim the credit, can be found on the IRS website.
The DOL has issued a fact sheet titled Tipped Employees Under the Fair Labor Standards Act (FLSA) that is available for download from their website. The fact sheet covers the application of the FLSA laws to tipped employees, including wage rates, tips and pooling, service charges, dual jobs and gives examples of typical issues employers and employees may encounter when handling tip income.
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