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 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.
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 Jan. 1, 2013. 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.
So, when is a tip a tip? The ruling provides that an employer’s characterization of a payment as tip is not determinative. Rather, a tip satisfies the following four factors:
- 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.
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 recharacterized 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.
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.
Update: The IRS has announced that its 2012 ruling on automatic gratuities has been delayed and will not go into effect until Jan. 1, 2014. "This extension is provided in order to allow businesses not currently in compliance additional time to modify their business practices and make needed system changes," the IRS notice said.