Tips on Identifying Service Charges

Does your organization automatically add “tips” for certain services—for example, parties of six or more in your restaurant?  Well, the IRS would potentially call that a service charge, and if you are an employer, you must ensure that you properly record, collect and pay FICA taxes on the amount paid out to employees.  Automatic gratuities—whether in the form of tips for large parties of restaurant patrons or porterage for large hotel groups—are commonly applied by many in the restaurant and hotel industries, and they are considered to be wages by the IRS.  However, most employers have assumed that these charges represent tips, and as a result, have assumed that the responsibility for reporting and paying taxes rests solely with the employees receiving the tips.

It seems that even amongst IRS auditors, this has been the assumption.  That is, until the IRS issued a revenue ruling in June 2012 to provide clarification on what it deems to be a tip versus a service charge. See 2012-26 I.R.B. 1032-1034.   The issue is important because employers are responsible for properly classifying service charges as wages (see 26 USC § 3111), and they may be subject to penalties if they fail to report and pay the FICA taxes owed for those charges.  It is also worth noting, because employers may be eligible to qualify for a general business credit on FICA for unreported tips, but they cannot take the credit for tips that are really service charges.  See 26 USC 45(B)(a).

How can you tell the difference?   According to the IRS, “tips” meet all FOUR of the following factors:

  1. The customer is not charged automatically,
  2. The customer has the unrestricted right to decide the amount of the charge,
  3. Generally, the customer can decide who receives the money,
  4. The charge is not dictated by employer policy or the subject of negotiation.

If you believe you have been adding automatic gratuities that would fail on one of these factors — yet you have been treating them as tips — you may want to reexamine your approach.  You may want to classify those charges as a service charge, and place the payment directly on the employee’s check, ensuring to both report it as a part of employment taxes and also, subject the payments to FICA taxes.

This is not a new rule, but the IRS believed it needed to provide more direction on the subject.  The agency intends to enforce the newly clarified standard retroactively, except under limited circumstances where it has not provided prior guidance.  For example, it has not, in the past, made it clear that tips charged automatically on large parties are considered a service charge.  Because of that, it will likely apply the rule to charges paid on or after January 1, 2013.  The agency has, however, identified in the past that automatic porterage is a service charge.  Therefore, those charges and any resulting penalties would be assessed retroactively.

Keep your eyes posted to this blog and/or to the IRS bulletins.  The agency is planning to solicit public comments on proposed changes to voluntary tip compliance agreements. Specifically, the IRS is considering significant changes to the Tip Reporting Alternative Commitment (TRAC) program and other variations of TRAC agreements.  2012-26 I.R.B. 1054.

We recommend that you consult your legal counsel to review your current practices and to help develop best practices for your tips and service charge reporting.