Mandatory service charges and their distribution among waitstaff have plagued the hospitality industry for years. Federal courts interpret the federal law differently and states have enacted their own statutes that place employers in constant uncertainty, depending on where they are located. Also, tip pooling arrangements have been a regular part of many restaurant operations and are generally allowed by both federal and state law. However, there are limitations as to who can participate and how much can be contributed to the tip pool. This will provide an overview of the guidelines involving tips, service charges and tip pooling, the current state of the law and some suggestions on how to stay compliant.
Tip v. Mandatory Service Charge In a ruling issued in June 2012 the Internal Revenue Service clarified the difference between a tip and a service charge for tax purposes under the Federal Insurance Contributions Act. The IRS determined that automatic gratuities (a percentage automatically added to a restaurant bill) are service charges, rather than tips for tax purposes. Revenue Ruling 2012-18 also determined that to the extent any portion of a “service charge” is distributed to an employee, it is wages for FICA tax purposes.
Generally, the burden of reporting tips falls on the employee. Employees that receive more than $20 in cash tips (cash, debit/credit cards) per month are required to report the tips to their employers by the 10th day of each month. The employer is then required to withhold FICA taxes, similar to non-tip wages. An employer is not liable for their share of FICA taxes if the employee fails to report tips.
However, effective January 1, 2014, employers are required to treat mandatory gratuities as “service charge wages” instead of tips. This directly affects an employer’s responsibility to report and pay FICA taxes, as well as, overtime calculations.
Under the new guidelines, the IRS stated that the difference between a tip and wage requires a factual determination considering all the circumstances. The IRS will generally categorize a payment as a tip (versus a wage) when: (1) the payment is made free of compulsion; (2) the customer retains the right to determine the amount; (3) payment is not subject to negotiation or employer policy; and, (4) the customer determines who gets payment.
As a result, automatic gratuities or service charges are no longer considered tips. Customers do not have a choice whether or not to leave a gratuity and are forced to leave a specified amount set by the employer. Such mandatory gratuities when distributed to the employee by the business are considered wages. As wages, they are not eligible for the FICA Tip Credit (The 45B Credit). For many years, restaurants have benefited from being allowed to apply a general business credit toward a portion of the employer’s social security and Medicare taxes paid on tips in excess of the federal minimum wage as of January 1, 2007.
Also, since automatic gratuities and service charges are not tips, they cannot be included in the tip amount that social security and Medicare taxes are paid on, which takes some tax credit off the table for restaurants. This credit is claimed on Form(s) 8846 and 3800.
However, where a restaurant provides a customer a receipt with recommended tipping amounts i.e. 15%, 18% and 20%, the IRS does not classify the amount left as wages because the customer has a choice to determine the amount, is free from compulsion and determines the amount of the gratuity, if any, left. Therefore, this situation would support a finding that this is truly a tip and not considered wages.
Absent choice by the customer, an automatic gratuity when paid by the restaurant to the employee is considered part of the employee’s wages. This means the burden rests on the employer to incorporate automatic gratuities as part of the employee’s wages as opposed to relying on the employee to report their tips. Service charges/automatic gratuities are considered part of the employees’ overall rate of pay. As such, where a member of the waitstaff works over 40 hours in week or 8 hours in a day in some states like California and receives a portion of the automatic gratuities, this amount must be factored into the total wages earned and factored into that day’s or week’s regular rate of pay (i.e. total wages ÷8 or ÷ 40). It is this figure that is used to determine the overtime rate of pay (1 ½ times the regular rate of pay) for any overtime earned.
This means employers now have the additional burden to make sure their pay systems calculate automatic gratuities as part of employees’ wages and use them to determine the regular rate of pay for a particular day or week for purposes of correctly calculating overtime. As such, employers must pay close attention to avoid the underpayment of overtime wages.
Federal law as to Tip Pooling The federal law on tip pooling adopts standards which are protective of employees’ right to tips.
The Fair Labor Standards Act (FLSA) permits employer-mandated tip pools among employees who “customarily and regularly” receive tips, such as waiters, waitresses, bellhops, bussers and service bartenders. Under the FLSA, it is made clear that employees such as chefs, cooks, janitors, and dishwashers are not allowed to share in the money contributed to a tip pool. A court in one case has held that hosts and hostesses who greet customers and perform some table attendance duties might be included in a tip pool. However, this holding is not all encompassing so a case-by-case analysis needs to be applied to determine applicability.
The FLSA forbids any arrangement where any part of the tip received becomes the property of the employer. A tip is the sole property of the tipped employee or employees appropriately participating in the tip pool.
The Department of Labor (DOL) also mandates that the pooling arrangement must be “customary and reasonable” and can not require an employee to contribute a greater percentage of their tips other than what is customary and reasonable. Although there is no definition or exact percentage of what the DOL deems “customary and reasonable,” the wage and hour division has found in cases where contributions of 15 percent or less of an employee’s tips to be acceptable. Contributions of greater than 15 percent are not statutorily forbidden but may require the employer to show that such a percentage is “customary and reasonable” for that community.
States also have similar definitions of allowable tip pooling. An issue of much interpretation and debate is whether employers may mandate that tips/gratuities be pooled and distributed among certain employees as a mechanism for ensuring that gratuities are shared by all employees in the “chain” of customer service also known as tip pools. Tip pools, whether voluntary or mandatory, are generally permitted for restaurant employees as long as:
Tip pool participants are limited to those employees who contribute to the chain of service bargained for by the patron;
No employer or agent of the employer takes or receives any part of the tips intended for employees; and
The tips are distributed among the pool participants in a fair and reasonable manner.
Pooling tips for redistribution is not required, nor is a written agreement or policy required to allow a tip pool.
“Chain of Service” Eligibility However, the definition of “chain of service” has continued to be refined and evolve with opinions both by federal and state wage and hour divisions and the courts. For example, in 2005, California’s Department of Labor Standards Enforcement issued an opinion regarding tip pools stating that employees eligible to participate in a tip pool include anyone who contributes to the “chain of service bargained for by the patron, pursuant to industry custom.” This opinion letter described the “chain of service” to include bussers, bartenders, hostesses, wine stewards and front-room chefs (e.g., chefs at a sushi bar or who prepare food at the patron’s table). The opinion reaffirmed that no employer or agent with the authority to hire or discharge any employee or supervise, direct, or control the acts of employees may collect, take, or receive any part of the gratuities intended for the employees as their own. In other words, despite any tip pool container as is often seen at coffee shops, the owner(s), manager(s), or supervisor(s) of the business can not participate in the tip pool, even if these individuals provide direct table service to a patron. This is the case even if the guest intended to leave the tip for an owner, manager, supervisor, or agent of the business who actually provided service to the patron. Given the broad definition of the Labor Code, an agent could include a floor manager or shift supervisor if that person has the ability to direct or control the acts of employees.
However, recent court decisions have allowed shift supervisors in certain situations to share in gratuities. This situation was dealt with in lawsuits by Starbucks baristas as to the company’s practice of permitting shift supervisors to share tips. At the Starbucks stores, the collective tip box was divided among the entry-level employees and the shift supervisors. A trial court in San Diego, California initially ruled that California law prohibited managers and supervisors from sharing such tips and awarded over $105 million dollars in damages. However, this decision was reversed with the Court of Appeals holding that shift supervisors are eligible to share in the tip pool, reversing the lower court decision. The Court found that shift supervisors performed the same tasks as baristas because their primary duty was to serve food and drinks. Chau v. Starbucks, Corp. 174 Cal App 4th 688 (2009). This case has not been overturned and even other states including New York cited the Chau case to support allowing shift supervisors to participate in the tip pool based on their duties being more akin to baristas. See, Barenboim v. Starbucks Corp., 2013 N.Y. Slip Op. 04754 (June 26, 2013) wherein New York highest court found given that shift supervisors performed the same duties as baristas that they could share in the tip pool. Therefore, there seems to be consistency among states as to the role of shift supervisors working at Starbucks. However, consistently courts have found assistant store managers should not be included in the tip pool because they have too many managerial duties, including hiring and firing, so as not to be classified as wait staff.
These cases have also brought up the concept of a customer service team (consisting of one or more entry-level and one or more shift supervisors) who rotated jobs throughout the day and spent most of their time performing the same customer service tasks, thereby supporting the Starbucks tip pooling arrangement. Generally, a customer who places a tip in a collective tip box was found to understand that it would be shared by all service employees and these cases appear to be guiding law.
As to tip pooling, the industry has adopted a standard that distributes the majority of the pooled gratuities to waiters and waitresses, followed by a smaller percentage to bussers, and a still smaller percentage to other categories of employees who provide limited direct table service. There is no specific cap placed on the percentage of tips waiters and waitresses can be compelled to “tip out”. As will be explained below, the current state of the law limits who can participate in a mandatory tip pool.
New Developments as to Tip Credit and Tip Pooling The most recent issue that has arisen involves who can share in the tip pool and whether “back of the house” employees like dishwashers, food scrapers, chefs, and cooks can share in the tip pool. Under the Federal Labor Standards Act (“FLSA”), the Department of Labor (“DOL”) has consistently taken the position that employees who do not provide direct service to the customer are not allowed to participate in a tip pool. This would mean that kitchen staff who do not have direct service contact would not be viewed as being valid participants to share in a tip pooling arrangement.
However, inconsistent interpretations of the FLSA among various appellate courts have created confusion for both employers and courts regarding the applicability of valid tip pools. One of the most interesting interpretations of the FLSA occurred in early 2010, when the Ninth Circuit Court of Appeals (which covers the states of California, Nevada, Oregon, Washington, Arizona, Alaska, Idaho, Montana and Hawaii) held that an employer could require servers to pool their tips with non-tipped kitchen and other “back of the house staff,” so long as a tip credit was not taken and the servers were paid minimum wage. Cumbie v. Woody Woo, Inc., 596 F.3d 577 (9th Cir. 2010). According to the court, nothing in the text of the FLSA restricted tip pooling arrangements when no tip credit was taken; therefore, because the employer did not take a tip credit to reach the minimum wage, the tip pooling arrangement did not violate the FLSA.
In response, the DOL initially announced that in accordance with the Woody Woo decision, it would permit employers in the Ninth Circuit to impose mandatory tip pooling on employees who did not customarily and regularly receive tips. However, on April 5, 2011, the DOL issued regulations that directly conflicted with the holding in Woody Woo. At that time, it was unclear whether the DOL would enforce the new regulations against employers in the Ninth Circuit. In early 2012, the DOL clarified its position on tip pooling by fully rejecting the Ninth Circuit’s decision in Woody Woo. Therefore, employers could no longer require mandatory tip pooling with back of the house employees. In conjunction with this announcement, the DOL issued an advisory memo directing its field offices nationwide, including those within the Ninth Circuit, to enforce its rule prohibiting mandatory tip pools that include such employees who do not customarily and regularly receive tips.
As a result, several restaurant trade groups and Wynn Las Vegas challenged the 2011 rule change in separate cases, seeking to enjoin its enforcement. (The plaintiff employers all required their employees to participate in a tip pool that included both tipped and non-tipped employees, and they did not take a tip credit against the minimum wage.) Both federal district courts concluded that the DOL lacked authority to make the rule change as a result of Woody Woo and, moreover, that the substance of the DOL’s revision contradicted Congress’ clear intent.; therefore upholding Woody Woo and allowing a mandatory tip pool with back of the house employees states where a tip credit was not allowed.
In response, the DOL appealed but set forth language that it would not seek to enforce these 2011 new regulations within states located in the Ninth Circuit area of responsibility that do not allow a tip credit. On February 23, 2016, a sharply divided panel of the Ninth Circuit Court of Appeals (which covers the states of California, Nevada, Oregon, Washington, Arizona, Alaska, Idaho, Montana and Hawaii) ignored its prior precedent issued in 2010 and upheld the 2011 DOL rule change. The majority concluded that the Fair Labor Standards Act’s (FLSA) “clear silence as to employers who do not take a tip credit has left room for the DOL to promulgate the 2011 rule and rejected the notion that the appeals court itself had foreclosed the agency’s ability to do so by virtue of its 2010 decision in Cumbie v. Woody Woo, Inc., 596 F.3d 577 (9th Cir. 2010). This decision means that even in states where no tip credit exists that employers can no longer mandate a tip pool distribution that includes employees who are not in the chain of service or have direct contact with customers i. e. cooks, dishwashers. These employees are by this decision are prohibited under the regulation from being part of a mandatory tip pool. Oregon Restaurant and Lodging Associationv. Perez, 816 F.3d 1080 (9th Cir. 2016)).
A petition for rehearing en banc before the full panel of Ninth Circuit judges, rather than the usual three, was requested. On September 6, 2016, the Ninth Circuit denied the petition but ten of the judges joined in a sharply worded dissent that laid out a path for a potential appeal to the U.S. Supreme Court. The Oregon Restaurant decision is directly at odds with the Fourth Circuit Court of Appeals decision in Trejo v. Ryman Hospitality Props.,Inc., 795 F.3d 442 (4th Cir. 2015). Due to this “circuit split”, the National Restaurant Association, the National Federation of Independent Business and other hospitality groups filed briefs to join the Wynn’s prior petition for U.S. Supreme Court to decide whether the DOL acted within its statutory authority when it barred restaurants from including kitchen staff in tip pools. It will be up to the U.S. Supreme Court as to whether it elects to take this appeal and resolve the split in the federal courts of appeal.
Practical guidelines for compliance As a result of the Ninth Circuit decision in Oregon Rest., a company located in the jurisdiction of the Ninth Circuit which includes California is no longer allowed to impose a tip pool that allows employees who are not directly in the line of service to be a part of a tip pool arrangement. “Back of the house” employees like cooks, kitchen staff and dishwashers who have no contact with the customer going forward are barred from sharing in a tip pool even in a state where the tip credit does not apply. The pending appeal before the U.S. Supreme Court may change this law but for now, mandatory tip pools cannot include members of the team without any direct contact with the customer.
As a result, going forward, employers should take the following steps to limit liability on tip pooling claims:
Only include employees who actually contribute to the chain of service and per industry custom regularly are subject to receiving tips. Such individuals typically include those who provide direct service to the customer.However, the chain of service industry custom and case law does support employees with even limited direct customer contact to receive a smaller percentage of the tip pool as the industry custom has evolved to a recognition of these employees being essential to the chain of service. For example, cooks who prepare food in front of the customers or dishwashers who also serve as food runners might be allowed to be part of the mandatory tip pool.
Rely more on what the employee actually does in his/her job versus their job title. For example, an employee carrying the title of “waitress” whose only job is to prepare food outside the view of patrons or without personal contact with patrons will likely not be in a tip pool. Also an employee who has greater contact with the customer should receive a greater percentage of the tip pool than employees who have less direct interaction with the patron.
Do not distribute any portion of a mandatory tip pool to any manager or supervisor, even if that manager or supervisor provides direct table service and/or the tip was left by the patron specifically for that individual.
Make sure that the tip pool is distributed to participating employees in a reasonable manner, proportionate with the employees’ direct interaction with the customers.
Review your current tip pooling arrangement and revise it as needed to comply with this new decision.
For more specific questions, as to prevention and allowable tip pooling policies, it is important to consult competent legal counsel who understands both the hospitality industry and wage and hour issues and can analyze those issues given your specific circumstances and policies.
This report was reviewed for legal accuracy and updated in 2016 by Wilson Elser Moskowitz Edelman & Dicker LLP.
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