One of the most common topics I am asked to speak about with restaurateurs is tips. One of the first things you have to do upon hiring an employee is determine his rate of pay. When it comes to a tipped employee, it is not as simple as it may sound. Logic dictates that restaurateurs pay as little as legally possible to tipped employees because these employees are truly working for their tips. Labor law allows restaurateurs to deduct a tip credit (a.k.a. allowance) from minimum wage. In New York State, the current minimum hourly wage is $6.00 and the tip credit is $2.15, making the effective minimum rate for a tipped employee $3.85 ($6.00 minus $2.15). The minimum wage and credit are changing as of January 1, 2006 to $6.75 and $2.40 respectively; making the effective minimum rate you can pay a tipped employee $4.35 per hour. The tip credit can only be taken if the employee reports tips per hour equaling or exceeding the amount of the credit. It is important to note that if a tipped employee who is being paid at the $3.85 rate works more than 40 hours in a week they must receive overtime pay for those hours over 40, at a rate of $6.85 ($9.00 minus $2.15) per hour.
Once a tipped employee is hired and working, he is responsible for reporting his tips to his employer. Over the years I have been asked many times by servers, “How much of my tips do I need to report?” Employees seem to think that they only have to report tips equal to 8% or 15% of their sales or in some cases they think that they only have to report credit card tips but not cash tips. The reality is that employees must report 100% of their tips. If by some chance the total tips that an establishment reports is less than 8% of the total gross sales, then additional tips are allocated to employees who have not exceeded that threshold and taxes are owed.
Now that the employee has reported his tips, the employer has to withhold appropriate taxes. Once again this process is not as simple as it may sound. In a non-tipped situation, the taxes are calculated based on wages earned and deducted from those wages resulting in a net pay. In a situation where there are tips involved, the taxes are calculated on the tips plus the wages. If the tips were already distributed to employees, the taxes can only be withheld from the wages. It is quite common in situations like this for the taxes to exceed the wages, resulting in a negative net pay. In most cases taxes are then “reversed” to get the net pay up to zero. The employee may naively think that his wages “covered” his tax liability and he is happy with the tips he has in his pocket. Unfortunately, in most cases there has been an under withholding of taxes and the employee could be in for quite a surprise when he files his annual tax returns and discovers he owes the government a lot of money. He may need to make estimated tax deposits during the year to avoid paying penalties when he files his returns. Another solution to this problem is for the employer to not reimburse the credit card tips on a nightly basis. If those tips are held back until payday, and included on the employee’s paycheck, some of those tips can go towards paying taxes and there is no under withholding. This technique also allows tipped employees to participate in medical and retirement plans.
So much for employee issues regarding taxes on tips, how about employers? Let’s start with some bad news. Employers have to pay 6.2% Social Security tax (on tips and wages up to $90,000 annually) and 1.45% Medicare tax (on all tips and wages). This tax is also known as FICA. Here’s some good news. Employers receive a credit for this FICA tax paid on tips above minimum wage. Let me explain. If an employee earns $5.30 per hour in tips and is paid $3.85 per hour in wages then $4.00 per hour is eligible for the FICA Tip Tax Credit. (Federal minimum wage is $5.15; minus $3.85 is $1.30. $5.30 minus $1.30 is $4.00.) The employer will get a credit of $ .31 per hour (7.65% times $4.00). If there are 20 tipped employees all working 40 hours per week the restaurateur will have a credit of almost $13,000 by the end of the year. This is a dollar for dollar credit against federal income taxes. Here is some more bad news. Employers also have to pay unemployment insurance tax, federal and state, on tips. Some good news is that you only pay federal on the first $7,000 per year on combined wages and tips, and state (in New York) on the first $8,500.
No tip discussion would be complete without touching on the issue of service charges. Tips (a.k.a. gratuities) and service charges are very different. Tips must be left at the discretion of the customer and are the sole property of the employee. Service charges, on the other hand, are determined by management and some or all can be passed on to employees and treated as wages. I know there is an ongoing philosophical debate about whether it is better to have a service charge added to the bill and pay your service staff solely a wage or keep the traditional environment of a small wage plus tips. I won’t comment on the philosophical side, but I do want to note some financial differences. First of all, eliminating tipping would also eliminate the benefits of the FICA Tip Tax credit which I discussed earlier. Secondly, tips are not subject to Workers’ Compensation insurance and “converting” tips to wages may have an impact on insurance costs. Finally, overtime costs would be greatly increased in a service charge environment due to the fact that base rates would be much higher.
I don’t know about you, but I’m all tipped out, my chair is tipping over, and I have no more “tips on tips”.
Michael Busch is President of Payroll Computing Services.
PCS is a payroll service provider and consultant that specializes in the restaurant industry.