Restaurateurs and wait staff beware: beginning this month, the IRS will classify automatic gratuities not as "tips," but as service charges reportable as regular wages which are subject to payroll tax withholdings.
Rev. Rul. 2012-18 provides that automatic gratuities – like that automatic 18 percent added to the bill for a party of six or more -- are service charges, rather than tips, for tax purposes. To the extent any portion of a "service charge" is distributed to an employee, it is wages for FICA tax purposes. Thus automatic gratuities are not included in the wait staff's tip reports, but are to be treated by the employer in the same way as the wait staff’s hourly wages.
The original rule technically went into effect in June 2012, but the IRS pushed back enforcement until January 2014 to allow restaurants time to comply. So, starting now, those automatic gratuities for large parties are to be treated as service charges, not tips, for FICA purposes.
The fact that the restaurant and wait staff call such payments "tips" is not determinative. According to the IRS, it's not a "tip" unless it satisfies four criteria:
The payment must be made free from compulsion.
The customer must have the unrestricted right to determine the amount.
The payment should not be the subject of negotiation or dictated by the employer policy.
Generally, the customer has the right to determine who receives the payment.
These changes will obviously result in more paperwork and added costs for restaurants, and, as a result, many restaurants are changing policies. Some restaurants have resorted to simply providing the customer the calculation of the tip at 15, 18 or 20 percent, regardless of the size of the party. That shift may be an unintended positive consequence of this ruling for those who would prefer to cruise through life without doing math at all.