Service businesses such as restaurants, bars, and salons often receive tips in addition to their payments for services rendered. Tips are usually given in appreciation for exceptional service or to ensure that the individual server or salesperson receives a portion of the profits. While business owners do not receive income from the tips, they are often required to match FICA taxes, which include Social Security and Medicare taxes, on these payments. Under a special tax credit called the FICA Tip Tax Credit, though, small business owners can claim a tax credit that reduces their share of the matching FICA taxes on tips. 

What is a Tip for Tax Purposes?

Before considering the FICA Tip Tax Credit, though, it's important to learn exactly which payments the IRS classified as "tips". According to the tax code, a tip is a payment that the customer volunteers to make. It must also be up to the customer to decide how much to pay and to whom the payment is made. This means that mandatory gratuity that is shared among all of the servers in a restaurant may not meet the IRS standard of a "tip". In order for companies to claim the FICA Tip Tax Credit, they can only figure the IRS tax credit based on specific taxes that apply to IRS-defined "tips".

Which Tips Qualify for the FICA Tip Tax Credit?

Along with the IRS standard for determining tips, there are some customer payments that do not qualify for the tax credit at all. These include payments that consist of service charges that are distributed to all employees and tips that are used to meet the federal hourly minimum wage amount. For example, if a restaurant owner pays his or her servers an hourly wage that is less than the federal hourly minimum wage, he or she cannot claim the FICA Tip Tax Credit on the amount of tips that it takes to reach the hourly minimum.

How to Calculate the FICA Tip Tax Credit

To calculate the amount of the FICA Tip Tax Credit, business owners can simply multiply the FICA tax percentage of 7.65 percent by the amount of IRS-defined tips received by the business that year. They can then claim the entire amount of their tax as their FICA Tip Tax Credit by using Form 8846 "Credit for Employer Social Security and Medicare Taxes Paid". However, if their employees are earning less than the federal hourly minimum wage, then the tips used to meet that standard must be deducted before calculating the credit.

Business owners who collect tips during the course of their business can use the FICA Tip Tax Credit to get a tax break on their portion of Social Security and Medicare taxes. To receive the credit, though, these entrepreneurs must understand which tips qualify for the credit. They may consider customized tax planning services to ensure they correctly report the credit on their annual return.