Calculating Wages with FICA Tip Credit

Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

The FICA tip credit was established to encourage employers to accurately report the tips their employees make. In this lesson, we'll take a look at how the FICA tip credit works, including how it is calculated.

Tips

Lauren owns a restaurant. It's hard to keep her business afloat, so she doesn't want to pay any more in taxes than she has to. She's wondering if she has to pay taxes on her employees' tips. Could she avoid that expense?

Tips must be reported for tax purposes. That means that the employee pays income tax on those tips and that the employer pays FICA taxes, which include the social security and Medicare employer contributions.

So what can Lauren do? To help her understand how she can save money, let's look at the FICA tip credit and how it is calculated.

FICA Tip Credit

Lauren thinks it might be beneficial to her if she just doesn't report her employees' tips. That way, she doesn't have to pay the FICA taxes on them. But this is both illegal and immoral, and Lauren could get in big trouble for skipping out on FICA taxes.

In order to encourage employers to correctly report tips and pay taxes on them, there is a federal tax credit known as the FICA Tip Credit, which allows employers to receive a tax credit for FICA taxes paid on most tips. That credit directly reduces a business' income and therefore the taxes they have to pay.

To understand how the FICA tax credit works, it's important to understand that many tipped employees are paid less than minimum wage. For example, Lauren pays most of her servers $3 per hour with the understanding that they will get enough tips to make up the difference between that and the minimum wage.

The FICA tax credit is calculated only using what employees make above minimum wage. So Lauren won't get a tax credit for all the FICA taxes she pays, only the FICA tax amount that exceeds minimum wage for her employees.

Calculations

The calculations for the FICA tax credit sound a little complicated to Lauren. But we'll take her through how to figure it out.

The first step is for Lauren to calculate the total compensation for an employee for the current pay period. This is the wages an employee earned just for showing up plus their tips. Let's take Lauren's server Henrico.

In the last pay period, Henrico worked 40 hours and was paid $3 per hour for those hours. He also reported $400 in tips during that pay period. His total compensation then is (40 x 3) + 400 = $520.

Next, Lauren needs to calculate what Henrico would have made for working those hours if he was paid minimum wage. For the purposes of this tax credit, minimum wage is calculated at $5.15 per hour if the state has adopted the federal minimum wage, or the state's minimum wage if it is higher than the federal.

Let's assume that Lauren's state has the same minimum wage as the federal minimum wage. Henrico's pay for 40 hours of work would be 40 x $5.15 = $206.

Now Lauren has to calculate the difference in what Henrico actually earned and what he would have earned on minimum wage. This is simple subtraction, using the two numbers we just calculated: $520 - $206 = $314. So Henrico earned $314 more this pay period than he would have if he was just paid minimum wage.

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