Service charges definition and guidelines
UPDATE: What constitutes a service charge vs. a tip?
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.
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 these 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. 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.
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.
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, 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.
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 wait staff works over 40 hours in week or 8 hours in a day in 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 for any overtime earned.
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.
When is a tip really a service charge and overtime calculation?
The IRS 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. Comply with this distinction.
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 her a portion of the automatic gratuities she earned that day, that amount counts toward the overall wages she earned that day and must be factored into the calculation of her 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 her overtime pay rate (one-and-a-half times her 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 she earned that week, the amount of automatic gratuities she was paid is considered part of her wages. Accordingly, her total wages for that week, including the automatic gratuity amount, should be divided by 40 hours in order to determine her regular rate of pay. Again, this is the regular rate of pay that must be used to determine her 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. These must be considered as wages.
This means employers need 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.
Distribution of Service Charges
Now, while the IRS does not have authority to issue regulations to or interpretations of the Fair Labor Standards Act (FLSA), the IRS ruling does implicate some important issues concerning the minimum wage and overtime laws. Specifically, 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. Of course, employers also have the option to pay it out to the employees who worked the events as wages, bonuses or commissions.
Unlike tips, service charges belong to the employer and generally the employer can keep the income from the service charges or in the alternative distribute it to employees. It is generally the employer’s decision as to how to allocate. However, some California municipalities like the City of Santa Monica, City of Emeryville and Oakland have passed ordinances which require hospitality entities to distribute all of the service charges to its employees and do not allow the employer to keep any of the service charges. Therefore, with these exceptions to the general rule, restaurants need to make sure they understand the unique rules that may apply in the jurisdictions where they do business.
As a result, going forward, employers should take the following steps to make sure they are properly classified as service charges:
- 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-this is a tip and not a service charge
- Charge sales tax on all service charges regardless of the amount paid to the employee
- Clearly delineated on a receipt that a service charge is added
- Calculate the amount of service charge paid to an employee in an overtime calculation
- Monitor the jurisdiction rules as to any special wage and hour ordinances as to service charges
Consult with your tax advisor or attorney to determine the proper method of taxing service charges and paying your employees
For more specific questions as to service charges or wage and hour questions, 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 2017 by Wilson Elser Moskowitz Edelman & Dicker LLP.