Understanding payroll taxes can be difficult as there are multiple parts to these taxes. Businesses with tipped workers have it even harder as their employee’s compensation is made up of hourly wages, regular tips, service charges, and more. These types of businesses are allowed to take a tax credit, called the FICA Tip Credit, against their employees that earn tips are part of their wages. Before we dive into the FICA Tip Credit, lets take a look at what FICA is.
What is FICA?
FICA, or Federal Insurance Contributions Act, is a US law that requires a tax on employee wages. These taxes are used to fund the federal Social Security and Medicare programs. As part of this law, employers also have to match the amount of taxes that each individual employee contributes. The employer is responsible for withholding this tax from employee wages. These FICA contributions are mandatory for both the employee and the employer. The rates for these taxes are set annually. A portion of the total amount funds the Social Security program and the other portion funds the Medicare program.
What is the Tip Credit Piece?
Businesses with tipped employees that earn over $20 in tips in a month must pay taxes on the tips that those employees receive. As with all other income, employers are responsible for withholding the portion of FICA taxes on tipped income. The FICA Tip Credit was enacted to ensure businesses with employees who receive tips report those tips as income to the government. This is done by allowing businesses to claim a credit against its’ business taxes for FICA taxes paid on said tipped income.
The Tip Credit also allows employers to pay a much lower percent of minimum wage in direct wages to its’ tipped employees. Employers must prove that the employee makes at least minimum wage when direct wages and tips are combined at the end of the week.
As of December 28th, 2021, there have been changes made to the FICA Tip Credit. These changes clarify when a business can use the credit and pay their tipped workers less than minimum wage. You can read about those changes here.
How to Calculate the Tip Credit?
The FICA Tip Credit is taken as a credit on a business’s annual tax return using form 8846. The FICA Tip Credit rate is 7.65%. Businesses can get a credit of 7.65% of the tips reported over the minimum wage threshold. Paper Trails will provide the calculations and reporting for you and your accountant will prepare this for you as part of your annual business tax return.
John works 25 hours at a Maine restaurant. John earns $6.38 per hour and receives $500 in tips.
- Step 1: Calculate John’s hourly earnings. 25 hours x $6.38/hour = $159.50
- Step 2: Add John’s wages and tips. $159.50 + $500 = $659.50
- Step 3: Calculate the wages paid at minimum wage. The minimum wage threshold for FICA Tip Credit is $5.15/hour based on the Small Business and Opportunity Work Act of 2007. 25 hours x $5.15/hour = $128.75
- Step 4: Subtract this figure from John’s total wages and tips. $659.50 – $128.75 = $530.75
- Step 5: Multiple this figure by the FICA Tip Credit rate of 7.65%. $530.75 x .0765 = $40.60
In this example, this business may receive a credit of $40.60 for this week for this employee.
Remember, with the new changes, effective December 28th, 2021, only those hours where tipped employees are performing tipped related work may be eligible for the tip credit.