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Can the FICA Tip Credit Lower Your Business Income Taxes?

Contributor: Felicia Tjong, Payroll Manager

February 16th, 2024 | 6 min. read

By Tony Calavitta

Can the FICA Tip Credit Lower Your Business Income Taxes?

Can you guess the top 5 business expenses that employers in the food and beverage industry encounter?

Food? Check!

Labor? Check!

Rent? Check!

Taxes? Che...Wait what?! (Bet you didn’t see that cost on your business menu!)

Business taxes actually fall within this group of elite expenses. In fact, on average, the taxes that employers in the food service sector pay each year amount to 57% and 20% of what they spend on rent and labor respectively.

If you are an employer in the food and beverage industry, this statistic probably has you feeling salty.

What if there was a sweet – and federally recognized – way to reduce your annual business income taxes?

Well, there is!

In this article, we will discuss FICA taxes as an appetizer to explore how the FICA Tip Credit could be an opportunity to prevent you from dishing out unnecessary tax dollars. Keep reading to learn how this federal tax provision may be your secret ingredient to MICHELIN™ Star tax savings.

What are FICA taxes? The fundamentals

The Federal Insurance Contributions Act (FICA) is a mandatory payroll tax that funds two important programs: Social Security and Medicare. These programs provide vital benefits to millions of Americans, including retirees, the disabled, and children of deceased workers.

FICA taxes are made up of two wage-based taxes: a Social Security tax and a Medicare tax.

Both employees and employers are legally required to pay FICA taxes on a portion of an employee's taxable wages:

  • For employees, these contributions are withheld from their regular pay and represent a future investment in their retirement benefits, like Social Security retirement income and disability insurance, and healthcare benefits through Medicare.

  • For employers, paying FICA taxes is a fundamental aspect of payroll management and ensures compliance with federal laws.

How do FICA taxes work for employers?

As an employer, you are not just responsible for paying employee wages – you also must contribute to your employees’ Social Security and Medicare.

Here’s more information on your FICA responsibility:

Equal Contributions

Both you and your employees contribute equally to Social Security and Medicare taxes. The rates are fixed percentages of the wages you pay to your employees.

For Social Security, the rate is 6.2% for both the employer and the employee, amounting to a total contribution of 12.4%.

For Medicare, the rate is 1.45% for both the employer and the employee, amounting to a total contribution of 2.9%.

Contribution Constraints

Social Security:

There's a wage base cap on the amount of earnings subject to Social Security tax.

This cap changes from year to year based on inflation and other factors. For example, the wage base limit in 2024 is $168,600.

This means that when an employee earns above this annual amount, neither you nor the employee are responsible to pay Social Security taxes on wages above this limit.

Medicare:

There's no wage base cap for Medicare taxes.

This means that all covered wages are subject to Medicare tax.

However, there is an additional Medicare tax of 0.9% that high-earning employees must pay. This tax only applies to employees who make over $200,000 each year. As an employer, you are not responsible for matching this extra Medicare charge, but you are responsible for withholding this additional tax from employees' wages once they earn above the threshold.

But what about tipped income? Do FICA taxes apply?

If you are an employer in the food and beverage industry, you’re probably wondering how this tax breakdown works for employees who receive service tips (After all, it’s no secret that tips increase an employee’s earning potential).

So, do higher wages as a result of gratuities mean that, as an employer, you are responsible for a higher FICA tax contribution?

In short, the answer is: Yes.

For the purpose of determining your FICA tax contribution, all tips are considered income. This means that tipped income is taxed in the same way that direct wages are and the same contribution rates apply to your employees’ gross income.

Does this mean that employers in the food and beverage industry get the short end of the stick? Are employers in the service industry just expected to bear a higher tax burden?

In short, the answer is: No.

How does that even make sense? Right?

This is where the FICA Tip Credit comes into play.

The FICA Tip Credit – How employers in the food and beverage industry can turn tips into tax savings

The FICA Tip Credit is a tax provision designed specifically for employers in industries where tipping is customary, such as restaurants and bars.

It allows employers to claim back a portion of the FICA taxes they pay on their employees’ tipped income.

This tax credit is for the full 7.65% FICA tax contribution and can be claimed for reported tips that exceed the Federal minimum wage.

In other words, with the Federal minimum wage set at $7.25 per hour, employers are eligible to receive the FICA Tax Credit on any tipped income that employees receive beyond this hourly wage.

It is important to note that the FICA Tax Credit is not a deduction from the employee's income. Instead, it is a credit against the employer's tax liability, intended to offset the higher burden of FICA taxes on employees’ tips. Ultimately it offers service industry employers tax savings to counter the higher contribution expectation.

The purpose of the FICA Tip Credit is twofold:

  1. It acknowledges the unique financial dynamics of tipped industries, where wages are often supplemented by tips, resulting in higher employer FICA contributions.

  2. It incentivizes accurate reporting of tip income by potentially reducing the employer's tax burden when tips are properly reported.

In essence, the FICA Tip Credit serves as a bridge between the traditional wage system and the reality of gross wages in tipped industries. It provides a measure of tax relief to employers affected by tipped wages. By allowing employers to claim a credit for a portion of their share of FICA taxes on tips, the government is encouraging fair, transparent taxation and reporting standards for all employee income.

With this in mind, understanding and utilizing the FICA Tip Credit is crucial for businesses in the food and beverage sector - it can lead to substantial tax savings, making it an essential aspect of sound financial planning and tax compliance.

But what about state-specific minimum wage laws? Does the FICA Tax Credit still apply?

The FICA Tip Credit is a federal tax provision, meaning it applies to all eligible businesses in the United States, regardless of the minimum wage paid under state law.

And, again, regardless of the minimum wage employers pay under state law, the FICA Tip Credit calculation will still be based upon the tipped income employees receive in excess of the Federal minimum wage.

For example:

The current Federal minimum wage is $7.25 per hour.

The current state minimum wage in California, however, is $16.00 per hour.

Let’s say you operate a restaurant in California where tipping is customary (Note: For the sake of this example, we will not factor in any variable local minimum wage laws).

So, how much do you have to pay your employees in direct wages? $16.00 per hour.

If your employee makes $50.00 in tipped income, how much of this exceeds the Federal minimum wage? $50.00

And, how much of this tipped income qualifies for the FICA Tax Credit? $50.00

What if your employee makes $500.00 in tipped income, how much of this exceeds the Federal minimum wage? $500.00

Then, how much of this tipped income qualifies for the FICA Tax Credit? $500.00

Because the minimum wage in California is higher than the Federal minimum wage requirement, 100% of the tipped income your employees report is eligible for the FICA Tax Credit.

This means that even if your employee made $5,000,000 in tipped income, this entire amount would be eligible for the FICA Tip Credit.

Does this mean that employers in the food and beverage industry can receive a profitable return from the FICA Tax Credit? Are there limits to how much tipped income you can claim?

Is there a cap on how much tipped income employers can claim as part of the FICA Tax Credit?

While there's technically no cap on the amount of tipped income you can claim for the FICA Tip Credit, it's important to remember this is an annual tax credit, not a refund.

This means the credit reduces the annual business taxes you owe to the Internal Revenue Service (IRS). In other words, it can't give you money back, but it can significantly minimize your business tax burden.

Think of it, instead of a refund, as a discount:

  • First, you calculate your FICA taxes based on all employee income, including wages and tips.

  • Then, the FICA Tip Credit lets you subtract a portion of the FICA taxes paid on eligible tips (those exceeding the federal minimum wage).

  • Finally, this reduces your final tax bill, potentially bringing it down to zero for the portion covered by the credit.

(If you need to file a business tax return amendment with the IRS to claim a credit from a previous year, you must consult with a Certified Public Accountant (CPA) to complete the process. In this scenario, you may be entitled to a refund.)

Want to maximize your savings on business income taxes? Take the next steps

If you've made it this far, you now realize the significant impact the FICA Tip Credit can have on reducing your business's tax burden.

And you probably want to see those savings in your business account, right?

Here at Combined, we are here to help turn that realization into your reality! Our experienced team of payroll specialists is ready to step in and help you spend less on business taxes so you have more to invest in the continued success of your business.

Get started today!

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This article is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel for legal advice.