Beginning January 1, 2014, the IRS is requiring employers to classify automatic gratuities as service charges. Service charges distributed to employees are treated as regular wages, subject to normal payroll tax withholding rules. This is a change that will mean added costs and paperwork for restaurants, upfront withholding of federal taxes, and delayed time in receiving the take home pay for waiters and waitresses.
The IRS defines a tip as having the following characteristics:
- The payment must be made free from compulsion (the customer is not required to pay a tip but voluntarily does so);
- The customer must have the unrestricted right to determine the amount (the restaurant cannot automatically calculate the gratuity);
- The payment should not be the subject of negotiations or dictated by employer policy (the restaurant does not negotiate with the customer for a gratuity amount); and
- Generally, the customer has the right to determine who receives the payment (as opposed to the employer.)
If the above criteria are not met, the amount is considered a service charge and treated for all tax purposes as regular wages. For example, if a restaurant automatically applies an 18 percent gratuity on checks for parties of six or more, the automatic gratuity is considered a service charge instead of a tip. If the customer decides to give an additional tip amount (in excess of the automatic 18 percent), that extra amount is considered a tip if the other criteria were also met. As a result, some restaurants may consider adding suggested tip amounts regardless of the party size, allowing customers to choose to tip more or less, in order to ensure that the amount will not be classified as a service charge.
If the automatic gratuity is considered to be a service charge rather than a tip, under federal law, service charges belong to the restaurant and become a part of the restaurant’s gross receipts and may be retained or distributed as management sees fit. Service charges distributed to employees are treated as wages and can be used to assist employers in meeting their requirement to pay employees minimum wage. Unfortunately, since automatic gratuity is a service charge and not considered a tip, employers cannot use those amounts when calculating the Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips, otherwise known as the tip credit, even if management chooses to distribute the amount to the employees.
Connect with a Baker Tilly advisor to help your company handle these payments correctly. This may also be a good time to revisit how sales tax is charged against these types of payments.