The Federal Insurance Contributions Act tax, or FICA, is a shared tax — paid in equal parts by employers and employees — that helps fund Social Security and Medicare programs.
Because FICA applies to all taxable compensation, service-based tips are included in the “amount owed” calculation. This condition places a financial burden on service industry employers: While customer-paid tips constitute a large percentage of employee income, the employer doesn’t directly benefit from that income, and yet, they are required to pay taxes on it. Historically, this has led to the underreporting of tip income. In 1993, the FICA Tip Credit was introduced to provide tax relief and increase tip reporting among restaurant employers.
In its simplest form, the FICA Tip Credit states that restaurant industry employers can file for a dollar-for-dollar income tax credit for FICA taxes they paid on employee tips. Some additional conditions must be met, most notably that employers can only claim credit for tip income that exceeds the statutory amount of $5.15 (i.e., the former federal minimum wage, and the rate still used for FICA credit purposes). In other words, if an employee makes less than $5.15 per hour, the employer will not get credit on any tip earnings required to bring that employee up to the minimum level; tip earnings beyond that amount would be eligible for the credit, thus allowing for substantial savings on the part of employers.
At present, this tax credit is available only to the restaurant industry. However, efforts are underway to extend this legislation to other service-based industries.