MANDATORY SERVICE CHARGES versus TIPS AND SURCHARGES
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On June 20, 2012, the Internal Revenue Service (IRS) issued Revenue Ruling 2012-18 to clarify and update existing guidelines on taxation issues affecting the hospitality industry. In particular, the ruling helped clarify the distinction between tips and service charges:
According to a previous ruling promulgated by the IRS (Rev. Rul. 59-252) and further clarified in Rev. Rul. 2012-18, a tip is narrowly defined as: (i) an amount of money presented by a guest free from compulsion; (ii) a payment that the customer has the unrestricted right to determine the amount of; (iii) a payment whose amount cannot be the subject of negotiation or dictated by employer policy; and (iv) generally, a payment in which the customer can dictate and determine the recipient. If these four factors are absent, under Rev. Rul. 59-252, the automatic or non-discretionary charge is not a tip and if any portion of the charge is distributed to an employee, it is considered wages for FICA tax purposes. The same factors must be examined with respect to automatic gratuities that are assessed for large parties at a restaurant.
Although the ruling took effect immediately, the IRS understood some businesses may need to make significant changes to their automated or manual tip reporting systems in order to comply, so it provided that, in specified limited circumstances, the distinction could be applied by regulators beginning January 1, 2014. That date has now come and gone, so there is no doubt that all employers must be fully aware of the implications of the ruling.
This policy presents a myriad of problems to operators in the hospitality industry, and in particular to companies that are in the business of hosting banquets, private or similar events because it has long been industry practice for these types of businesses to add a mandatory “gratuity” or service charge to their banquet contracts or invoices.
Further, now some restaurants are adding a surcharge to their receipts to defray costs from a myriad of options over the last several years including but not limited to minimum wage, healthcare, paid sick leave, restrictive scheduling and the current state of the law that does not allow restaurants to mandate tips to employees who do not regularly interact with customers. As such, these surcharges likewise need to be viewed and analyzed for taxation purposes.
First let us think about how service charge, surcharge and tips affect a company from a tax and reporting perspective. Starting in 1994, many 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 with respect to their employees’ cash tip earnings (IRC 45 B). However, the policy set forth in Rev. Rule 2012-18 means that the credit would not apply with respect to service charges, because the mandatory charges do not qualify as tips. In addition, the restaurant should not be reporting the service charges paid out to the employees as tips on their payroll reports, but rather as wages. This also means that while completing Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, the service charges distributed to the employees (assuming it is more than 10 percent of the sale) and the respective sale should not be included on the form. Last, for income tax purposes, the Gross Receipts from the event would include the service charge as income and the service charge paid out to the employee would then be reported as Salaries and Wages on the business tax return. All of the above differs from the treatment that would have applied if the charge was considered a tip.
On December 23, 2016, the California State Board of Equalization made it clear that surcharges are also a taxable event. The BOE states that: “The Revenue and Taxation Code (RTC) provides that sales tax is imposed on the gross receipts from the retail sales of tangible personal property in this state, unless the sale is specifically exempted from taxation by statute. The sales tax is imposed upon the retailer for the privilege of selling tangible personal property at retail in California. RTC section 6012, “Gross receipts,” provides that the taxable gross receipts include all amounts received with respect to the sale, with no deduction for the cost of the property sold, materials used, labor or service cost, or any other expense of the retailer passed on to the customer. As explained by RTC section 6012, any expense of a restaurant passed on to customers in the form of a surcharge must be included in taxable gross receipts. Since there are no specific sales and use tax exemption for a surcharge imposed by a restaurant, retailers may not claim the cost of the surcharge as a deduction on their Sales and Use Tax return. Therefore, restaurants that include a separate surcharge on customer bills must include the surcharge amount in the calculation of tax.”
As a result, to the extent a restaurant elects to distribute a surcharge to its employees, it will be treated in the same manner as a mandatory service charge in that it must be reported as Salaries and Wages on the business tax return.
Now, while the IRS does not have authority to issue regulations to or interpretations of the Fair Labor Standards Act (FLSA), the ruling does implicate some important issues concerning the minimum wage and overtime laws. Specifically, can an employer apply the tip credit to an employee’s wages if he or she is working a shift where an automatic gratuity or service charge has been added to a guest’s bill? The answer is relatively simple if an employee works a “banquet shift” or at a restaurant where the employer’s policy is to charge a mandatory gratuity or automatic service charge to all patrons. In this scenario, the employer may not take advantage of the tip credit for the simple reason that the employees are not earning any gratuities, as defined by the IRS and the regulations to the FLSA. In this scenario, the employee must be paid the regular minimum wage for the time spent working the banquet or private event. (Currently the federal minimum wage is $7.25 per hour, California state minimum wage is $10.00 per hour if less than 25 employees and $10.50 with 26 employees or more – but certain municipal jurisdictions have implemented even higher minimum wage rates. The employer needs to comply with the highest minimum wage where it is located.) Because the mandatory service charges are not considered to be tips under federal law, employers within jurisdictions that adopt the FLSA in its entirety could conceivably keep the proceeds of the mandatory gratuity or service charge, or pay it out to the employees who worked the events as wages, bonuses or commissions. The same is true of surcharges which are treated the same way for tax purposes as service charges.
Another issue to consider is that an employer who pays out a portion of the mandatory gratuities or service charges to employees may have to recalculate its employees’ overtime rates (if the employees work more than 40 hours in a week or 8 hours a day for businesses in California). Because the regulations consider these payouts to be wages rather than tips, that money would count toward an employee’s regular rate of pay and therefore must be factored into the overtime rate calculation.
The situation becomes much more problematic when an employee is serving a large party with an automatic service charge added onto the bill and simultaneously serving several smaller parties with no service charges all in the same shift. Because it is unclear under the current regulations whether an employee working under this “hybrid” scenario would be considered to be engaging in a “customarily and regularly tipped occupation,” employers in this situation are facing an administrative nightmare that could expose the company to Department of Labor audits (and collective action lawsuits) if not treated or calculated correctly. Accordingly, we strongly recommend that employers micromanage their schedules to avoid having an employee simultaneously provide service to guests who are leaving totally voluntary tips and to other guests who are paying mandatory gratuities or service charges.
In contrast, when is a tip really a service charge? The ruling provides the following illustration of an alleged tip that is actually a service charge: A restaurant’s policy of adding an 18 percent service charge to the bill for parties of six or more is a service charge rather than a tip because the customer did not have the unrestricted right to determine the amount of the payment – it was dictated by the restaurant’s policy – and the customer did not make the payment free from compulsion. On the other hand, a bill with sample calculations of different tip amounts, where the actual tip line is left blank, is truly a tip.
How do you ensure a tip is really a tip? To ensure a tip is not actually a service charge according the IRS, make sure the tip line and total amount on any bill is left blank for the customer to complete in his or her discretion. While a restaurant may include sample calculations on the bill of different tip amounts (e.g., 15% = X), these must be clearly identified for reference purposes only so the IRS does not determine a certain amount is being mandated from the customer.
Why does it matter whether a payment is a tip versus a service charge?
Service charges are considered wages, and, therefore, 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 Jan. 1, 2007 (i.e., $5.15 per hour).
As the ruling makes clear that 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.
Tips and wages are reported on separate lines of the quarterly payroll tax return (Form 941). Incorrectly characterized service charges should be re-characterized and an adjustment made to Form 941 via tax report Form(s) 4666 and 4668.
When completing Form 8027 (Employer’s Annual Information Return of Tip Income and Allocated Tips), service charges distributed to employees and the respective sale should not be included on the form.
Some business may have to change their automated or manual reporting systems to comply with this distinction.
Employers who pay out a portion of the automatic gratuities or service charges to employees may have to recalculate its employees’ overtime rates. The ruling considers these payouts to be wages, rather than tips, so that money counts toward the employee’s regular rate of pay and should be factored into the overtime calculation.
How does this work in practice? Let’s say an employee works nine hours in one day, and is thus entitled to one hour of overtime pay. If you have paid him a portion of the automatic gratuities he earned that day, that amount counts toward the overall wages he earned that day and must be factored into the calculation of his regular rate of pay (i.e., total wages ÷ 8 hours). In turn, this is the regular rate of pay that would need to be used to determine his overtime pay rate (one-and-a-half times his regular rate of pay) for the one hour of overtime.
If the same employee works more than 40 hours in a week and is paid a portion of the automatic gratuities he earned that week, the amount of automatic gratuities he was paid is considered part of his wages. Accordingly, his total wages for that week, including the automatic gratuity amount, should be divided by 40 hours in order to determine his regular rate of pay. Again, this is the regular rate of pay that must be used to determine his overtime pay for time worked in excess of 40 hours during the week.
The same analysis applies as to overtime if an employee works in California more than 8 hours in a day. For that day, the overtime rate with the automatic gratuity amount, should be divided by the 8 hours in order to determine that day’s regular rate of pay.
Finally, although a service charge on a restaurant bill will most frequently be encountered, restaurants should be cautioned that auto-gratuities paid for catering, banquets, weddings and other amounts mandated by employer policy would likely be covered as well.
As to surcharges, as set forth above, if they are distributed to employees they are wages and should be treated as service charges. Likewise, given recent comments by several City Attorneys like San Diego, it is probably prudent that a restaurant disclose up front that the meal is subject to a surcharge and the percentage i.e. on the menu, in a prominent sign or posting or even a card at the table. Surcharges are allowed but to avoid any claim of false or misleading advertising, disclosure to the customer would be a prudent and a conservative approach of any mandatory additional charge be they called a service charge or surcharge. What is the solution to avoid confusion between tips and service charges? There are a few options and restaurant owners may not like any of them. Here are some suggestions:
Indicate a “suggested gratuity” on the customer’s receipt but do not add it to the total on the receipt allowing the customer to designate the gratuity voluntarily
Charge sales tax on all service charges and any separate surcharge line item, regardless of the amount paid to the employee
Eliminate all service charges and automatic gratuities
Consult with your tax advisor or attorney to determine the proper method of taxing service charges and paying your employees
This report was reviewed for legal accuracy and updated in 2017 by Wilson Elser Moskowitz Edelman & Dicker LLP.
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