Automatic Tips? Not So Fast!
Those mandatory 18% tips on checks for large dining parties will get more expensive for restaurateurs starting January 1, 2014. Until now, these charges have been classified as tips for income tax purposes, and left to employees to report as income. Employers have been able to take an income tax credit on Medicare and Social Security payments that they make on employees’ reported tip income. Under an IRS Ruling taking effect next month, the mandatory tips will be treated as service charges, and included as employees’ regular wages for calculating withholding tax and pay rates. As a result, employers will no longer be eligible to take an income tax credit, may have to pay increased overtime rates, and will have more complicated payroll accounting.
IRS Revenue Ruling 2012-18 makes clear that if a charge to the customer is mandatory, it is a service charge/wages, and cannot be counted as a tip. This is not a popular change for employers or employees, as it complicates restaurants’ accounting and delays payment to servers. As a consequence, when a service charge is passed through to the staff, servers’ hourly rates will differ from each other depending on whether tables served are large or small, and a server’s hourly rate may even differ over the course of a payroll period! To further complicate matters, the server’s overtime rate is calculated on this varying base rate. If a restaurant fails to include the mandatory tips as wages, overtime wages can be miscalculated, leaving an employer potentially liable under the Fair Labor Standards Act. Employees don’t like it, either: They receive tips immediately, but must wait until payday to receive wages, which are subject to full withholding. The new Ruling shifts the reporting obligation from employee to employer. Under current law, servers who receive more than $20 in tips in a month (either directly from a customer, through the employer, or under a tip-sharing agreement) must report them to their employer within ten days after month-end. Employers must collect income and payroll tax on tips reported this way. The new IRS Ruling says that the large-party mandatory tips are service charge wages that are subject to withholding and reporting by the employer, not the employee. The employer’s tax bill will increase, too. The full amount of the service charge must be included in the restaurant’s gross revenue, and is subject to income tax. Until now, hospitality employers could 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 in 2007. As the new Ruling makes clear that mandatory service charges are not tips, they cannot be included in the tip amount that Social Security and Medicare taxes are paid on, and the employer therefore loses eligibility for the FICA Tip Credit (The 45B Credit). So how do you make sure that a tip is a tip? What an employer calls it doesn’t matter. Instead, the IRS will look at four factors to determine that a payment is more likely a tip than wages:
- The payment cannot be compulsory.
- 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’s policy.
- Generally, the customer has the right to determine who receives the payment.
Several large chains have eliminated the large-party automatic service charge. Following the example in the Ruling, they have substituted sample calculations of 15%, 18%, and 20% tips on receipts, in which a customer may fill in any of those amounts, or none at all. The Ruling was issued in 2012, but implementation was delayed at the industry’s request to give time to change reporting systems for compliance. The Ruling says that it does not change policy, but clarifies existing policy. IRS field agents are now directed to examine for compliance, so employers should make sure that reporting systems and business practices are in place to distinguish properly between tips and wages, and should review records to determine whether any adjustments to past reporting are needed.
If you have any questions on this, or any other employment law issue, please contact Margaret Breen at 206.254.4495 or via email at firstname.lastname@example.org. Of course, you can always contact any member of the Retail, Hotel & Restaurant team; we’re happy to help.