If you have tipped employees, you may be eligible to use tip credits when you run payroll, if your state allows it.
A tip credit allows you to pay tipped employees less than the minimum wage as long as tips bring their earnings up to that minimum amount. Basically, it allows you to lump together your employees’ tips and hourly wages to equal the minimum wage. The credit itself is the amount of money you do not have to pay in a particular pay period because that amount was earned in tips by your employee.
How to calculate a tip credit
It’s best to use a payroll provider or CPA to calculate your tip credits, but here’s an overview on how it works.
- Check if your state allows tip credits: If it’s legal in your state, then you can move onto claiming the credit.
- Decide the hourly rates for your tipped employees: As you set your hourly rates, or “cash wages,” make sure they comply with your state and federal minimum cash wages. The federal minimum cash wage as of 2018 is $2.13 per hour. However, some states may have their own minimum cash wage that overrides the federal minimum.
- Tell your team: According to the US Department of Labor, you need to tell tipped employees about the credit so they understand why they’re being paid less than minimum wage.
- Document your tipped employees’ tips and hours worked: Record the amount of time your employees worked and the amount of tips each employee earned. This ensures that your payroll provider or CPA calculates paychecks correctly. Careful records also protect your business from an audit from the IRS or Department of Labor, as you can prove that you pay at least the minimum wage.
- Calculate your tip credit: Here comes the fun part. You usually calculate the tip credit when figuring out your employees’ wages for the pay period. The formula for getting to your tip credit is:
Minimum wage – cash wage = the tip credit
As an example, let’s say you pay the federal minimum wage ($7.25) and the federal cash minimum wage ($2.13). If you do the math, you get:
$7.25 – $2.13 = $5.12.
So, your tip credit is $5.12. But it doesn’t just end there. Which brings us to the next step:
- Calculate the tip credit for that pay period. Now you need to calculate the maximum amount of tip credit you can claim for the tip credit that pay period.
Time for an example. Let’s say one of your tipped employees worked eight hours during a pay period and made $100 in tips. To calculate your tip credit for the pay period, multiply the credit by the number of hours they worked:
$5.12 x 8 = $40.96
So, your tip credit is $40.96 for that employee. You can claim the credit as long as your employee made at least minimum wage for the pay period.
- Sum up your employees’ earnings for the pay period to see if you can claim the tip credit. The total tip credit you’re able to claim for each employee depends on:
- The number of hours they worked that pay period, and
- If their tips ensure they are paid at least minimum wage.
So, let’s see if your employee’s earnings meet or exceed the minimum wage.
First, we need to calculate the minimum wage:
Hours worked x hourly minimum wage = minimum wage
8 x $7.25 = $58.00
So, the employee must make a minimum of $58.00 during that pay period.
Now let’s calculate what the employee actually made during the pay period before tips, which is:
Hours worked x hourly cash wage = Total cash wage
8 x $2.13 = $17.04
So the total cash wage is $17.04.
However, the employee also received $100 in tips for a job well done. So, the total wages they received that pay period is:
Total cash wage + tips = total wages
$17.04 + $100 = $117.04.
So, the total amount that employee made in during the pay period is $117.04. Since that is more than minimum wage ($58.00), you’re able to claim the full $40.96 in tip credits for that pay period. That’s the amount you don’t explicitly pay because the tips covered the difference. Phew! You made it. The last step is to…
- Run payroll. Once you’ve calculated your tipped employees’ tips and hours worked for the pay period, enter all that information into your payroll system or tell your CPA. If you use a payroll provider like Gusto, it will calculate everything for you, including the tip credit, which can save you doing the above calculations by hand.
What if a tipped employee’s tips don’t bring them up to minimum wage?
If an employee’s tips don’t bring them up to at least the minimum wage, then you need to make up the difference.
As always, work with a CPA or payroll provider to ensure you’re capturing everything correctly. This stuff can get tricky!Updated March 5, 2018
This article provides general information and shouldn’t be construed as tax advice. Since tax rules may change over time and can vary by location and industry, please consult a CPA or tax advisor for advice specific to your business.