Tax Law Blog: Is This the End of Automatic Gratuities?

Starting in January, the IRS will begin treating automatic gratuities as wages which are subject to payroll tax withholding. Many restaurants add the automatic gratuity to large groups to ensure the server is tipped appropriately for large groups. The change comes as the IRS distinguishes “tips” and “automatic gratuities. While “tips” are voluntarily made, the IRS says “automatic gratuities” are mandatory payments, similar to a service charge, and therefore should be treated as wages, not tips. It’s up to the server to report tips as income on their personal tax return on the same line as wages. (On Form 1040, Line 7 is for “wages, salaries, tips, etc.”) The employer does not withhold tax on the amount of those tips that is not reported to the employer, and likewise does not report those tips to the IRS as wages of the employee. By treating automatic gratuities as wages, the employer will be required to withhold payroll taxes on the amount of automatic gratuities, just like it does on wages, and the gratuities will be shown as wages on a Form W-2.

The change in classification means more paperwork for the employer to keep track of the amount of the automatic gratuities, and also increased costs to the employer who is now paying payroll taxes on that amount. A Wall Street Journal article last week discussed certain restaurant chains considering changing their practices to get rid of automatic gratuities. One chain is already testing a new system in select cities, where instead of including the automatic gratuities, the bill calculates certain suggested tip amounts for the customer.

Most of the direct burden here is on the employer, though understandably there is also concern of the effect this will have on the employees receiving those automatic gratuities. The IRS ruling to clarify the treatment of automatic gratuities actually came out in July 2012, but the IRS delayed implementation at request of the restaurant industry and the concerns for the implementation. IRS Tax Topic 761 has more guidance for employers.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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