What Are Tip Credits and How Can Employers Take Advantage of Them?

Employees in traditionally tipped positions typically rely on tips to supplement their wages paid by their employers. For many, including those in the food and beverages industries, tips constitute a significant portion of their earnings. As an employer, if you are planning to take a tip credit as an allowance against your minimum wage obligation you must comply with applicable federal and state laws and regulations related to tip credits. As addressed more fully below, some jurisdictions do not permit an employer to take a tip credit.

What Is a Tip Credit?

Tip credits allow an employer to credit a portion of an employee's tips toward the employer's obligation to pay minimum wage. Tip credits are not deducted from employees' pay; instead, if permitted to take a tip credit, employers may claim a certain amount of gratuities the employer receives against their minimum wage requirement.

Who Do Tip Credits Apply To?

Tip credits can only be applied to a tipped employee — defined under federal law as an employee who regularly earns at least $30 per month in tips — and can only be applied to hours of work that produce tips or directly support tip-producing work as long as the directly supporting work is not performed for a substantial amount of time. A substantial amount of time is defined as more than 20 percent of the hours worked during the employee’s workweek for which the employer has taken a tip credit or a continuous period that exceeds 30 minutes.

This change — known as the 80/20 rule — was included in the U.S. Department of Labor, Wage and Hour Division, Final Rule titled “Tip Regulations Under the Fair Labor Standards Act (FLSA), Partial Withdrawal” that took effect Dec. 28, 2021. The rule has survived legal challenges from restaurant industry groups to this point, and on July 6, 2023, a federal court refused to block it. An appeal is expected, but the rule remains in effect.

If taking a tip credit, the tips earned by the employee must equal at least the difference between their direct cash wage and the minimum wage for the jurisdiction(s) in which the employee works. Employers are required to make up the difference if an employee’s combined wages (direct cash wage plus tips) do not reach minimum wage levels.

Non-tipped workers don't qualify for an employer to take a tip credit, and employers must pay these non-exempt employees at least minimum wage for all hours worked.

How Does a Tip Credit Work?

Tips can come directly from customers, or as part of a tip pool. With tip credits, an employer can credit a portion of an employee's tips toward the employer obligation to pay minimum wage.

As background, the Fair Labor Standards Act (FLSA) is a federal law that generally requires employers to pay their nonexempt employees at least the federal minimum wage, which is currently $7.25 per hour. The FLSA allows employers of certain employees to count a limited amount of the tips receive by tipped employees as a credit toward this federal minimum wage obligation. Employers may satisfy the federal minimum wage by paying a base hourly rate (a minimum of $2.13) and accounting for the remainder ($5.12) through the value of tips an employee receives. The employer must notify employees that their tips are being credited toward the minimum wage and employees must be able to retain all tips that they receive. Notice requirements are reviewed in DOL Fact Sheet #15.

Additionally, tipped employees are typically classified as nonexempt employees, which means FLSA standards such as overtime pay that apply to other non-exempt employees also apply to tipped employees. For example, if a tipped employee works more than 40 hours in a work week, the employer must pay overtime wages in accordance with applicable wage and hour laws.

State Laws on Tip Credit

While the FLSA requires that employers pay employees at least the federal minimum wage, state laws may differ. This is because many states have a higher minimum wage than the federal $7.25 per hour. Additionally, Alaska, California, Minnesota, Montana, Nevada, Oregon, and Washington do not allow employers of tipped employees to take a tip credit. Several states currently allow a tip credit, but require a higher direct or cash minimum wage be paid to employees. Other states may define tipped employee or when a tip credit may be taken differently than the FLSA. For these reasons, it's important that employers refer to the U.S. Department of Labor (DOL) website and/or the state website where employees are working for more information and applicable guidance on tip credit. The tip credit claimed for overtime hours worked by a tipped employee might not be different from the tip credit claimed for the employee’s non-overtime hours.

FICA Tip Tax Credit

As with any employer, food and beverage industries need to understand their responsibilities as they pertain to Federal Insurance Contribution Act (FICA) taxes. As part of this, accurately reporting the tips that workers receive may give restaurant employers access to another potentially valuable tax credit, known as the FICA tip tax credit.

What Is the FICA Tip Credit?

Employers with employees who earn gratuities are required to pay taxes on the tips their employees collect from patrons, as the tips are considered income under FICA. But restaurant employers may receive an incentive for accurately reporting their workers' tip earnings: an income tax credit called the FICA tip credit, which can potentially save restaurants hundreds of dollars per employee.

The FICA tip credit permits an eligible employer to credit a portion of the FICA taxes paid on certain tip wages against the business’s income taxes. This credit equals the employer's portion of the FICA tax, which is currently 7.65 percent. If an employee’s non-tip wages are less than $5.15 per hour, the credit equals the employer’s share of FICA taxes paid on the employee’s hourly tip wages after reducing that tip wage by the difference between the employee’s non-tip hourly wage and $5.15, according to the U.S. Treasury.

Who Does It Apply To?

The FICA tip tax credit is only available to employers in the food and beverage industry that have a tipped workforce. Unlike the tip credit under the FLSA, businesses in other industries are not eligible to claim this tax credit.

To be eligible for the FICA tip tax credit, restaurants must determine that all non-exempt employees are compensated at least the federal minimum wage for hours worked, which for this tip tax credit is $5.15. If the state where the restaurant resides has a higher minimum wage rate, the higher wage applies. Compensation may be totaled from different types of compensation received, such as hourly wages, tips, and gratuities that the staff member records, and meals that the restaurant provides to the employee.

Employees must keep an accurate record of daily tips, whether they come in the form of cash or credit. A total must be provided on an annual basis to the employer. This reported total is then used as the basis of income tax recording, Social Security payments, and other withholdings. Restaurants must follow up with employees as required to ensure this information is received.

How Do You Calculate the FICA Tip Tax Credit?

A FICA tip credit calculator can help you estimate how much of a tax credit you may receive. Here's an example of calculating FICA tip credit:

Sarah works at a restaurant. She earns $2.13 an hour, works 30 hours a week, and reports $250 in tips in a given week. Although the federal minimum wage has since been raised to $7.25 an hour, the FICA tip credit will continue to be based on the old minimum wage of $5.15 an hour, due to the Small Business and Work Opportunity Tax Act of 2007.

To determine Sarah's weekly wages, multiply her hourly wage by hours worked weekly:

$2.13 × 30 = $63.90

Add in her weekly reported tips:

$250.00 + $63.90 = $313.90

Next, calculate the wages paid at minimum wage by multiplying the minimum hourly wage rate ($5.15) by 30 hours worked:

$5.15 × 30 = $154.50

Subtract the first value ($313.90) by the second value ($154.50) to find the amount of tips in excess of minimum wage:

$313.90 — $154.50 = $159.40

Multiply that number by the employer's portion of the FICA tax to determine the tax credit:

$159.40 × 7.65% = $12.19

While that may not seem like a lot of money, if Sarah consistently works the same number of hours and earns the same amount of tips for 52 weeks, the potential annual savings could be $633.88. And the more tipped employees you have, the more savings you can realize.

Tip Pooling

While employers are generally prohibited from retaining any part of an employee's tips, they can organize a tip-pooling arrangement for tipped employees. In this setup, a portion or all of the tip money is collected and redistributed amongst the tip-earning staff, which might benefit employers and employees when there is a disparity between the tips received by employees in tipped positions key to the daily operations of the restaurant.

In relation to the FICA tip tax credit, a tip pool could affect how much of a tax credit you are eligible to claim. However, a tip-pooling arrangement could help offset the FLSA and/or state law requirements related to minimum wage for employees who may not otherwise receive enough in tips to make up the difference.

Paychex Can Help

Businesses in industries where employees are tipped face intricacies in payroll and taxes, as well as requirements to accurately report their workers' tip earnings. While the documentation — Form 8846 — to claim the credit seems simple enough, there are many stipulations and other factors of which owners may not be aware when it comes to the FICA tax. Consider working with a trusted and reputable payroll provider such as Paychex to help you through every step of the process.