Beginning January 2014, the IRS will begin enforcing guidance it published in a June 2012 ruling classifying automatic gratuities on restaurant checks as service charges and not tips. Many restaurants include automatic gratuities on checks for large parties or in the event of special promotions or discounts (Groupon or Scoutmob deals, for example) to ensure that servers get fair tips. Because automatic gratuities remove the element of customer discretion to voluntarily determine the amount to tip, however, the IRS will now treat automatic gratuities as regular wages and tax them accordingly, regardless of the employer’s designation of the payment on the customer bill as a “tip.”
For FICA tax purposes, the IRS advises restaurants that if any of the following factors are missing, employers should not presume a payment is a tip:
1) the payment must be made free from compulsion;
2) the customer must have the unrestricted right to determine the amount;
3) the payment should not be the subject of negotiation or dictated by employer policy; and
4) generally, the customer has the right to determine who receives the payment.
To illustrate the ruling goes on to offer the classic “parties of six or more” example where, in the event of a large party, an 18% charge on the cost of food and beverage is automatically added to the customer’s bill and then distributed to service employees, such amount is actually a service charge and not a “tip.”
Automatic gratuities falling into the “wage” category could create problems for restaurant payroll accounting for multiple reasons. First, restaurants eligible for a general business credit toward a portion of Social Security and Medicare taxes for employees’ cash tip earnings may lose some of that benefit now deemed attributable to “service charges.” Furthermore, since automatic gratuities will be treated as wages, that money will count toward and employee’s regular rate of pay for purposes of calculating overtime rates, which could vary from day to day.
The treatment of automatic gratuities as wages could disadvantage servers as well, since that money would be subject to upfront withholding of federal taxes and not paid out until payday, seriously inconveniencing wait staff accustomed to bringing their tip earnings home at the end of each shift. Service employees could also come under greater scrutiny in reporting their tips, a potential source of contention between them and their employers.
In light of these problems, what should restaurant employers do? Consider eliminating automatic gratuities in order to preserve your income-tax credit, avoid administrative headaches, and minimize hardship for your service employees. One alternative scheme to automatic gratuities is adding lines to customer bills with a few suggested tip amounts (with respective calculations), such as 15%, 18%, and 20% from which customers can choose. As long as customers are still free to enter any amount (including zero) on the tip line, the IRS has suggested this approach leaves enough customer discretion to still be a tip. A few restaurants have done away with tips all together, in favor of paying servers a higher hourly wage and charging a standard service surcharge on every bill. While this approach is significantly more straightforward from an accounting perspective, it eliminates some employer tax credits and may adversely impact employee motivation.