The FICA tip credit for restaurants may be the industry’s most simple, ubiquitous, and impactful tax incentive. Therefore, it’s essential to understand how the FICA tip credit and service charges work together, especially when considering different wage models. In this article, we’ll walk you through the history and fundamentals of the FICA tip credit calculation, along with real-life scenarios and examples to show its impact on different wage models.
What is the FICA Tip Credit?
A restaurant pays social security (6.2%) and Medicare (1.45%) tax on the wages it pays to employees, also known as the employer’s share of FICA (Federal Insurance Contribution Act) taxes, herein referred to as payroll taxes. The wages and payroll taxes paid are tax deductible for income tax purposes. A restaurant must also pay payroll tax on its employees’ tips. Although the payroll tax on these tips is generally tax deductible, the tips are not because they’re not a business expense; they’re simply collected by the restaurant and distributed to employees. As a result, a restaurant pays payroll taxes on wages that it has no control over and doesn’t get to deduct. For example, during a week in March, Jake works 40 hours as a server at Bella’s Bistro. Bella’s pays Jake $140 in wages ($3.50 per hour), and Jake makes $180 in tips. Bella’s covers its share of FICA tax on Jake’s entire $320 earnings. Bella’s Bistro gets to deduct $140 in wages and $24.48 ($320 x (6.2% + 1.45%) in payroll tax on its income tax return.
As you can imagine, this provides little incentive for restaurants to report their employee’s tip income, making operating a restaurant with thin margins even more challenging to sustain. Therefore, the FICA tip credit for restaurants was created via the Small Business Job Protection Act of 1996 to encourage proper tip reporting and help businesses offset payroll tax costs in the restaurant industry. The law introduced a tax credit for restaurants equal to their share of FICA taxes (Social Security & Medicare) paid on tip income exceeding the federal minimum wage of $5.15 per hour (the minimum wage at the time).
For example, the difference between the $206 ($5.15 x 40 hours) Jake would have received at a $5.15-per-hour minimum wage, and the $140 he received as wages is $66. This amount is subtracted from Jake’s reported tips for Bella’s tax credit purposes. Thus, only $114 of Jake’s tips ($180 − $66) is considered, so Bella’s FICA tip credit for the week is $8.73 ($114 x 7.65%). As a result, Bella’s Bistro receives a FICA tip credit for its share of payroll taxes paid on wages that exceed the $5.15 minimum wage. Understanding how to calculate the FICA tip credit for restaurants correctly is crucial for maximizing your tax savings.
Tax Benefits of the FICA Tip Credit and Service Charge for Restaurants
A tax credit differs from a tax deduction because it allows taxpayers to offset their income taxes dollar-for-dollar instead of claiming a deduction to reduce taxable income. However, you can’t double dip, so the portion of payroll taxes claimed as a FICA tip credit is considered nondeductible for tax purposes. For example, the payroll tax deduction on Bella Bistro’s tax return would be reduced by the FICA tip credit amount of $8.73, but Bella Bistro would get a $8.73 tax credit instead. Applying FICA tip credit for restaurants can significantly impact your profitability over time. Let’s illustrate this example by converting the example above into thousands and assuming the restaurant generates the following:
- $1m in revenue
- 333k for cost of goods sold (COGS),
- $140k in base wages to tipped employees at $3.5/hour
- $24,480 (7.65%) payroll tax on $140k on tipped employee base wages plus their $180k in tips
- $400k of other operating expenses, including non-tipped labor, occupancy costs, utilities, etc.
As you can see, the restaurant saves $5,675 in income taxes by claiming the FICA tip credit of $8,730.
Claiming the FICA Tip Credit
The FICA tip credit for restaurants is calculated by completing and attaching Form 8846 to your business tax return. You will need the tips received by employees on which you incurred FICA taxes and tips paid over the $5.13 federal minimum wage. You can calculate this manually using your payroll reports. However, most payroll processors offer a FICA tip credit report that does the calculation for you and even calculates the tax credit amount for reconciliation purposes. You must be reporting tips through payroll for this report to work accurately.
If the restaurant is a pass-through entity (S-corporation or Partnership) for income tax purposes, the credit is reported on each partner/shareholder’s schedule K-1 and flows through to their personal tax returns on Form 3800. The credit is tracked on the corporation’s tax return on Form 3800 if the restaurant is structured as a C-corporation for income tax purposes. The FICA tip credit is nonrefundable but may be carried back and forward under the general business credit carryover rules.
Restaurants Not Using the Tipped Minimum Wage and Tip Credit
The following restaurants may not utilize the tipped minimum wage or tip credit:
- Quick-service restaurants
- Restaurants in jurisdictions or states that don’t allow a tip credit (i.e., Alaska, California, DC, Minnesota, Montana, Nevada, Oregon, and Washington.
- Restaurants that have implemented service charges instead of tips
If you don’t utilize the tip credit when paying employees, the entire portion of tips paid to the employees qualifies for the credit. For example, if you charge your customers a 20% service charge and pay your employees a wage over the regular minimum wage (instead of tipped minimum wage) of $7.25/hour, you can claim a credit for the payroll tax paid on all the tips. Restaurants following this model will not benefit nearly as much from the FICA tip credit as those that utilize the tip credit. Assume Bella’s Bistro removes tipping and instead collects a mandatory service charge. It distributes the service charges to its employees by paying higher wages (instead of tips). As a result, Bella’s Bistro generates additional sales from service charges of $180k and pays out the entire employee earnings of $320k as wages. Below is the result:
In the illustration above, a restaurant with a service charge model incurs $5,675 more in income taxes than a restaurant that utilizes a tipping model and takes advantage of the FICA tip credit and service charges properly. This example doesn’t consider other detriments of a service charge model, such as the additional sales tax on the service charges collected from customers.
Conclusion
Paying FICA taxes on employees’ tips is a necessary evil, but the FICA tip credit for restaurants allows you to claim a credit towards your income taxes for most of the FICA taxes paid on tips. We recommend working with an accountant who understands the nuances and incentives related to the restaurant industry. Please feel free to contact us to learn more about how the FICA tip credit and service charges can benefit your restaurant’s bottom line.
If you want to learn more about filing taxes for your restaurant in 2025 and the most important deadlines and planning tips, please read our guest blog post on TouchBistro.
