Tips and service charges

By Eric Fullmer, Managing Member, Bourgeois Bennett, LLC

As of January 1, 2014, businesses are required to follow the guidelines previously established by the IRS regarding the proper characterization of tips and service charges.  The guidance covers employer and employee obligations under the Federal Insurance Contributions Act (FICA) with respect to tips received by employees and includes clarification of the classification of a payment as a tip or a service charge.

The distinction of a tip from a service charge presents the restaurateur which a myriad of reporting challenges and may cause the operator to re-think its practice regarding mandatory service charges for large parties or banquet events.

First, a tip is defined as:

·         A payment made by a customer free from compulsion,

·         The customer has the unrestricted  right to determine the amount,

·         The payment is not subject to negotiation or dictated by a restaurant policy, and

·         The customer has the right to determine who receives the payment.

Absent these factors, the additional amount added to a customer check is a service charge and not a tip.  The employer must report service charges in income from operations. Service charges distributed to employees are non-tip wages and would be deductible as salaries and wages by the restaurant.

The operator is now presented with some unique challenges in processing payroll.  Service charges paid to employees must be tracked separately from tips for purposes of minimum wage and overtime calculations.

Minimum Wage Calculations.  The current Federal minimum wage is $7.25 per hour.  If an employee works a banquet shift where the operator charges a mandatory service charge and the employee is not working as a tipped employee, the calculation is quite simple.  The employee must be paid at least $7.25 per hour, including any service charge distributed to the employee.  If an employee works a mixed shift in which they receive both tips and service charges, the hours worked can be considered tipped hours and the hourly wage paid to a tipped employee can be reduced to as low as $2.13 per hour by utilizing a wage rate credit for tips received by each employee.   Because service charges are non-tip wages, the amount distributed to tipped employees cannot be included to determine the tip credit against minimum wage. However, the service charges distributed to employees would be included in the hourly wages paid by the employer toward meeting the minimum wage requirement. 

Overtime.  Employees must receive overtime pay for hours worked in excess of 40 in a workweek at a rate not less than time and one-half their regular rate of pay.  In computing overtime, the regular rate of pay cannot be less than the minimum wage which is currently $7.25 per hour.  The regular rate of pay includes all regular hourly wages paid and now will include all service charges paid.  It does not include tips in excess of the tip credit.  Depending on the ratio of service charges and tips, this calculation may result in a higher overtime rate than when service charges were treated as tips. 

FICA tax credit.  Qualified employers may claim an income tax credit for Social Security and Medicare taxes paid or incurred on employees’ tips.  The tips included in this calculation will no longer include service charges distributed to employees.

Sales Taxes.  The Louisiana Department of Revenue is clear regarding sales tax on tips and service charges.  Tips and gratuities that are freely given by a customer over and above the price charged for food or drinks are not subject to state sales tax.  Any gratuity, tip, or service charge added as a separate item to the customer's bill as a requirement of the eating establishment is not subject to the sales tax if the full amount of the service charge is disbursed directly to the employees who customarily and regularly provide the service.  If any portion of the tip or gratuity is retained by the restaurant or lounge operator, then the entire amount of the gratuity becomes taxable.

Some operators reduce the tips and service charges paid to their employees by any processing fees charged by the credit card companies.  We offer concern on this point and question whether this practice could trigger a sales tax assessment under the literal reading of state law noted above.

Conclusion.  The implementation of these guidelines presents significant reporting challenges to operators and increases the administrative burden of compliance with payroll regulations.    As a solution to reducing the compliance burden with these new rules, the operator may want to consider eliminating the automatic service charge.  Instead, by offering suggested gratuities to the bottom of a check allowing the customer to determine the amount of the gratuity, all gratuities would be classified as tips and this reporting dilemma would be eliminated.  Employers may want to rethink service charge practices or prepare for the additional compliance burden that these rules require.

IRS begins enforcing mandatory gratuity rules Jan. 1

Beginning January 1, 2014, the Internal Revenue Service (IRS) will classify an automatic gratuity--the policy of adding an automatic tip to the bills of large parties of diners--as a service charge instead of a tip. The IRS regards service charges as regular wages, which must be reported for payroll tax withholding. 

The IRS ruling on automatic gratuities isn't actually new, having been issued in June 2012 as part of an effort to update earlier tax policies on tips. Implementation was delayed up to now, however, so that restaurants and related businesses had more time to comply. 

Mandatory gratuities are considered income to the restaurant. Most operators are familiar with this tax treatment when assessing a labor charge for banquets, but some are not aware that this concept extends to a mandatory tip amount or service charge.

A service charge is an amount automatically added to a customer’s bill by management. The IRS lists four factors, all of which must be present in order for the customer’s extra payment to be deemed a tip and not a service charge:

1.      The customer’s 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 the employer policy; and

4.      Generally, the customer has the right to determine who receives the payment.

IRS gives the following examples to distinguish when a gratuity left by the customer will be considered a tip or service charge:

EXAMPLE 1: A restaurant’s menu specifies that an 18 percent gratuity will be added to all customer bills. A customer’s bill for food and beverages includes an amount on the “tip line” equal to 18 percent of the price for food and beverages and the total includes this amount. The restaurant distributes this amount to the servers and bus-persons. Under these circumstances, the customer did not have the unrestricted right to determine the amount of the payment because it was dictated by employer policy and the customer did not make the payment free from compulsion. The amount included on the tip line is a service charge dictated by the restaurant.

EXAMPLE 2: A restaurant includes sample calculations of tip amounts beneath the signature line on its charge receipts for food and beverages provided to customers. The actual tip line is left blank. A customer’s charge receipt shows sample tip calculations of 15 percent, 18 percent and 20 percent of the price of food and beverages. The customer inserts the amount calculated at 15 percent on the tip line and adds this amount to the price of food and beverages to compute the total. Under these circumstances, the customer was free to enter any amount on the tip line or leave it blank; thus, the customer entered the 15 percent amount free from compulsion. The customer and the restaurant did not negotiate the amount nor did the restaurant dictate the amount. The customer generally determined who would get the amount. The amount the customer entered on the tip line is not considered a service charge.

If the gratuity is deemed to be a service charge rather than a tip, under federal law, service charges:

1.      belong to the establishment

2.      become a part of the establishment’s gross receipts

3.      must be considered as income to the employer, and

4.      may be retained entirely by management or distributed to employees in any amount management chooses.

Service charges that get distributed to employees are treated as wages under federal law. Distributed service charges may be used to help employers meet their obligation to pay employees the minimum wage. However, a compulsory service charge cannot be counted towards the tip credit.

Under the DOL regulations restaurants that automatically add a gratuity, for example, for large parties or catered events, cannot take a tip credit for the mandatory gratuity the establishment receives, even if management passes the gratuity on to employees. Instead, the mandatory-gratuity receipts are considered part of the employer’s receipts. The money paid from those receipts to employees is considered wages rather than tips.

Any portion of a mandatory gratuity charge that is retained by the employer is subject to sales tax.

It is important to note that restaurants should clearly inform guests of service charges and the amount of the charge before the guest orders, either by a conspicuous notice on the menu or by some other means.