Serving Up Trouble: IRS Ruling on Automatic Tips

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Restaurants and other employers in the hospitality industry are reminded that, as of January 2014, the Internal Revenue Service (IRS) will expect businesses to comply fully with its Revenue Ruling 2012-18. Among other things, this Ruling distinguishes between “tips” and “service charges.” This distinction is key, as the IRS only considers the latter wages, and this classification affects tax withholding, credits, and reporting, as well as wage and hour compliance.

If they have not already done so, businesses with tipped employees should critically assess their practices with respect to automatic tips. For example, the Ruling especially impacts restaurants and their longstanding practice of adding automatic service charges or gratuities to bills for parties over a certain number.

When is a payment a “tip” as opposed to a “service charge” under the Internal Revenue Code?

According to the Ruling, “the employer’s characterization of a payment as a ‘tip’ is not determinative.” In deciding whether a payment is a tip or a service charge, the Ruling sets forth the following factors and explains that, considering all of the underlying facts and circumstances, if any one of the factors is missing, the payment is likely a service charge, not a tip:

(1)  the payment must be made free from compulsion;

(2)  the customer must have the unrestricted right to determine the amount;

(3)  the payment should not be the subject of negotiation or dictated by employer policy; and

(4)  generally, the customer has the right to determine who receives the payment.

The Ruling offers illustrations of how these factors may apply. For example, a restaurant menu notes that an 18% charge will be added to bills for parties of 6 or more, and a party of 8 at the restaurant receives a bill including a line for 18% of the cost of food and beverages. This line is also reflected in the total for the bill.  If the restaurant distributes the 18% charge to employees, the IRS will treat this amount as a “service charge” and thus as “wages” within the meaning of the federal tax code.

On the other hand, consider a restaurant that includes sample tip amounts underneath the signature line on its charge receipts to customers (e.g., 15%, 18%, and 20% of the price of food and beverages). The tip line, however, is left blank. If the customer inserts the amount calculated for a 15% tip and adds this to the cost of the food and beverages to reach the total amount paid, the Ruling advises that this 15% amount would be considered a “tip” within the meaning of the federal tax code.

Wage and hour implications

Apart from the effect on federal taxes, the Ruling also has important consequences for wage and hour issues, particularly with respect to overtime calculations and tip credits.

“Service charges” distributed to employees may cause their hourly pay rate to fluctuate, as such charges vary from day to day and are treated as wages. An employee’s regular rate of pay, which is used to determine his or her overtime pay rate, should be calculated to include any “service charges” given to the employee in the particular workweek.

Additionally, under federal law, if certain requirements are met, employers may take a tip credit in satisfying their minimum wage obligations towards tipped employees. This tip credit amounts to the difference between a required direct wage and federal minimum wage. Employers should be careful that “service charges” distributed to employees are not treated as “tips” for purposes of the tip credit.

Businesses should beware, though, that some state laws may define “tips” differently than the IRS or the Fair Labor Standards Act. Thus, in distinguishing between “tips” and “service charges” and computing employees’ wages and overtime, employers need to consider the specific laws of each state in which they are operating.

Automatic gratuities may serve up more trouble for hospitality businesses than they are worth. In light of the Ruling, several restaurants, for example, have already eliminated automatic tips in order to avoid potential tax and legal complications. Businesses with tipped employees may want to do the same.