Maximizing the Federal Tip Credit for State and Local Income Taxes

The federal tip credit is a valuable benefit for restaurant owners. But, it is not just a federal benefit – many states and local taxing jurisdictions extend similar income tax credits or deductions to taxpayers in their jurisdictions.

How the Federal Tip Credit Works

Internal Revenue Code (Code) Sec. 45B provides a credit for Social Security and Medicare (FICA) taxes paid on employees' tip income to employers in the food and beverage industry. To be eligible for the credit, employers must follow very specific rules. Essentially, employers are permitted to pay tipped employees less than the minimum wage as long as employees earn enough in tips to make up the difference.

Tips are considered taxable income subject to FICA taxes, which are typically paid by the employer and employee in equal percentages. However, tips paid by customers to a restaurant’s employees are treated differently. Employers are required to pay both their share and the employee’s share of the FICA taxes even though the employer did not provide the tip income in the first place.

That’s where the federal tip credit comes in. It is essentially a tax credit for the FICA taxes paid by the employer on behalf of its employees for tips received from its customers. Sec. 45B gives employers a choice in applying the credit. Employers can claim the excess FICA wages as a deduction or they can take it as a credit against their corporate income tax. But, they cannot claim both. If employers claim the credit, the deduction must be added back. Similarly, if employers claim the deduction, the credit cannot be applied for.

State Income Tax Treatment

It would seem logical that the states would extend similar tax treatment, but this is not always the case. Not surprisingly, the states have differing treatment of the federal tip credit. In Pennsylvania for example, the statutes specifically provide employers with a deduction equal to the excess FICA wages. Oregon takes a broader approach – a taxpayer can subtract the amount of expenses not deducted on the federal return that is attributable to claiming a federal credit.

Where the complications begin are states that do not allow similar tip credits. In these states, the issue is whether employers can deduct the excess FICA wages they would have been allowed federally if no federal tip credit was claimed. In most states, the starting point for calculating state taxable income is federal taxable income. Federal taxable income is gross income less deductions, which includes FICA expenses paid by employers, but these expenses are not included in federal taxable income if a restaurant claims the federal tip credit.

It would seem equitable and reasonable for states to allow employers a deduction they would have otherwise been entitled to had they not taken the federal tip credit, but logic does not always prevail.

Neither Minnesota nor Virginia has comparable tip credits and neither state allows taxpayers to claim a subtraction for expenses offset by a federal credit unless specifically allowed by statute. Therefore, in these two states taxpayers are not permitted to take the excess FICA expenses as a subtraction on their state income tax returns.

Some states, Colorado for example, allow a deduction for wages that were reduced for federal income tax purposes in order to take a federal credit but only if they are Sec. 280C federal wage credits, which do not include the federal tip credit.

Like Colorado, New York State and City provide clear guidance on federal wage credits and have a provision in their laws that would seem to allow expenses that are not allowed federally as a result of a credit, however, neither jurisdiction has specific guidance regarding the federal tip credit. This inequity has resulted in appeals being filed – so stay tuned.

The Takeaway

Determining a state or local taxing jurisdiction’s treatment of tip credits may not be as clear as the federal tip credit. Employers should carefully review state laws and guidance to determine if they are entitled to state deductions related to the federal tip credit. Employers may also want to consider engaging a state and local tax specialist to maximize their tip credits.