The Tax Break-Down: the FICA Tip Credit
This is the thirteenth post in our blog series, The Tax Break-Down, which will analyze and review tax breaks under discussion as part of tax reform. Our last post was on the Foreign Earned Income Exclusion, which benefits U.S. citizens living abroad.
The FICA Tip Credit allows restaurants and bars to receive an income tax credit for employer-paid payroll taxes on employee tips. By eliminating the amount of payroll tax that employers pay, the credit theoretically eliminates an employer’s incentive to hide or underreport tip income. As a result, more revenue is likely to be collected from the employee’s portion of the payroll tax and larger wages are counted for the purpose of calculating Social Security benefits.
Currently, employers and employees each pay payroll taxes on wages to fund Social Security and Medicare (generally 6.2 percent each for Social Security and 1.45 percent each for Medicare). In the restaurant industry, where much of the employee’s compensation is in the form of cash tips, it is harder to determine and report wages. Workers who receive more than $20 in tips per month are required to report these tips to their employer, who reports this income and withholds FICA taxes.
Before the credit in 1982, the IRS estimated that only 15% of tip income was reported. After the credit was enacted, the IRS still estimated that fewer than 40% of all tips were reported in 1998; roughly $9-$12 billion in unreported income. In 2010, the IRS estimated it received only a quarter of the tip disclosure forms it was supposed to receive.
In the seven states where tipped workers must be paid equally to non-tipped workers, the credit is simple: employers get a credit equal to the amount of FICA tax they paid on tips, essentially making the FICA tax free. In the other 43 states where tipped employees can be paid less than minimum wage, employers cannot claim the credit for the portion of tips that are needed to bring a server’s wage up to $5.15, the minimum wage that prevailed prior to 2007.
Prior to 1987, restaurant employers were responsible for FICA taxes on tips up to the minimum wage, while employees were taxed on all wages and tips. After 1987, the minimum wage ceiling for employers was removed, but the restaurant industry demanded concessions for this tax increase. The FICA tax credit was enacted six years later, in 1993. Because Congressional budget rules make it difficult to reduce Social Security revenues, the credit was structured as it is today: employers pay full payroll taxes on tips above the then-current minimum wage ($5.15) and receive a dollar-for-dollar credit on their income taxes. When Congress raised the minimum wage in 2007, they left the minimum at $5.15 for the purpose of calculating the FICA credit.
The credit is not refundable, so employers must owe some taxes in order to claim it, but unused FICA credits may be carried back one year or carried forward up to 20 years.
How Much Does it Cost and Who Benefits from It?
According to the Joint Committee on Taxation (JCT), the credit for employer-paid FICA taxes on tips will cost $1.3 billion in 2013, which would be the equivalent of nearly $17 billion over the next ten years. About 60% of the tax benefit goes to C-corporations; the remaining 40% accrues to pass-through entities and individuals, according to JCT.
According to CRFB’s Corporate Tax Reform Calculator, eliminating the credit would allow for a 0.1 point reduction in the corporate rate.
What are the Arguments For and Against the Credit for Employer-Paid FICA Taxes on Tips?
Supporters of the FICA tip credit argue that this tax provision actively encourages accurate tip reporting, as employers are incentivized to report all tipped income in order to maximize the credit. They claim that the tax break actually raises money from increased reported tip income more than the cost of the credit, addressing a small portion of the $14 billion in FICA taxes that go uncollected each year. Further, by reporting and paying taxes on their full income, employees maximize their future Social Security benefits.
Opponents of this credit argue that no other tip-driven industry receives a similar credit, which unfairly benefits restaurants over other service industries. This credit encourages income in the form of tips rather than in the form of wages and puts downward pressure on wages for restaurant workers. They further argue that employers should not receive a tax benefit for simply complying with their legal obligation to report income. This credit can also be seen as a back-door subsidy to Social Security: the government loses income tax revenue in order to encourage higher FICA tax revenue.
What are the Options for Reform and What Have Other Plans Done?
The FICA tip credit could be maintained in its current form, repealed entirely, or modified in a number of ways. Fully repealing the credit, according to JCT, would raise about $8 billion. The revenue is about half the value of the tax expenditure, since some of the revenue gained from eliminating the credit would be lost as a result of lower reporting. Alternatively, cutting the credit in half might retain much of the reporting incentive but at a lower cost to the taxpayer.
Other options to reduce the cost of the tip credit include: raising the minimum wage for the credit ($5.15) to the current federal minimum wage of $7.25; disallowing the credit against the alternative minimum tax (as it was prior to 2007); or reducing the carry-forward period from 20 years to 15 years (as it was prior to 1997). Each of these options would save less than $1 billion over a decade.
If lawmakers instead wanted to expand the credit, they could make it available to other tip-dependent businesses such as hair salons, hotels, taxis, or tour guides.
Neither the Bowles-Simpson or Dominici-Rivlin plans include the FICA tax credit on the short list of tax breaks they would keep, choosing to repeal it in favor of lower rates and deficits. The Wyden-Gregg plan keeps the tax credit for employer-paid FICA taxes on tips.
Where Can I Read More?
- National Restaurant Association – Testimony to the Ways and Means Committee on Reforming the Internal Revenue Code
- The CPA Journal – Unreported Tip Income: A Taxing Issue
- Internal Revenue Service – Bulletin
- Internal Revenue Service – Voluntary Compliance Agreements – Restaurant Tax Tips
- Department of Labor – Minimum Wage for Tipped Employees
- Marketplace – IRS keeping Tabs on Restaurant, Bar Tips
- Wall Street Journal – IRS Rule Leads Restaurants to Rethink Automatic Tips
- SS&G – Tax Issues Specific to the Restaurant Industry
The FICA Tax Credit offers restaurants and bars an income tax credit which exactly offsets the amount paid in payroll taxes, eliminating the incentive to pay tips under the table. Although the credit may enhance tip reporting, some argue that the credit unfairly benefits restaurants over other tip-based industries and gives employers a payout for simply doing what they are supposed to do -- complying with tax law. While reforming the tax code, Congress could choose to keep this break, reform it, or repeal it in favor of lower tax rates and/or deficits.
