Do basis and risk limitations affect using tips credit?

• Author: Albin, John M.

Restaurants and bars are allowed a "credit for the portion of employer Social Security taxes paid with respect to employee cash tips" (tips credit) under Sec. 45B. Many restaurants and bars operate as corporations for liability reasons and have elected to be S corporations for tax reasons. In the preparation of the individual returns for the shareholders of these corporations, the issues of basis, at risk and passive activity need to be addressed, in that order. As these issues are reviewed, the question of the use of the tips credit also needs to be considered.

The tips credit is a general business credit allowed under Sec. 38. The computation of the tips credit, denial of the deduction for the amount allowed as a credit and the elective nature of the credit are covered in Sec. 45B. Neither Sec. 38 nor 45B deals with basis, at risk or passive activities. In order to determine if the use of the tips credit is limited by these provisions, each of these issues must be reviewed.

The general rule of Sec. 1366 allows the passthrough of credits to S shareholders as a separately stated item. The special rules for basis limitations under Sec. 1366(d) apply only to losses and deductions, and do not limit the amount of credits that pass through to the shareholder. Sec. 1366(f) limits only the gasoline and special fuels credits under Sec. 34 and does not limit other credits. Even though losses and deductions may not be available due to basis limitations, the tips credit may be used regardless of whether the stockholder has basis.

The at-risk limitations are covered in Sec. 465. These limitations deal only with losses from the activity and do not impose any limits on the passthrough of credits.

The passive activity limitations under Sec. 469 limit...