IRS Changes How Tips & Service Charges are Handled

As you may recall from a previous article, the new IRS rule on classifying tips and service charges was set to go into effect in June of last year, but the compliance deadline was extended to January 1, 2014. With the deadline quickly approaching, the IRS released its final rules on how to handle tips and service charges. No longer will an automatic gratuity for large parties be considered a tip, but rather a service charge.

As a result of these rules, businesses in the hospitality industry will be looking at how to handle tips and service charges. These changes will not be limited to just restaurant servers, but they will affect other areas of the service industry as well, including the following:

• Large Party Charge (restaurant)
• Bottle Service Charge (restaurant and night-club)
• Room Service Charge (hotel and resort)
• Contracted Luggage Assistance Charge (hotel and resort), and
• Mandated Delivery Charge (pizza or other retail deliveries)

The distinction between tips and service charges is important for income reporting purposes. Tips are owned by the employee/server and are not the property of the establishment. Generally, the employee must report these tips to their employer, and the employer must withhold the applicable taxes on this income.

Alternatively, service charges belong to the establishment and become part of the establishment’s gross receipts. Management has discretion over whether the service charge is distributed to employees, in part or in full. If the establishment chooses to distribute some or all of the service charge to an employee, it will be treated as part of their non-tip wages and included in Box 1 Wages on the Form W-2.

According to the IRS, “These non-tip wages are subject to social security tax, Medicare tax, and federal income tax withholding. In addition, the employer cannot use these non-tip wages when computing the credit available to employers under section 45B of the Internal Revenue Code, because these amounts are not ‘tips.'” With these changes, we could see many establishments doing away with automatic service charges since it will add an additional reporting burden to the establishment. Not only in determining tips versus non-tip wages from service charges, but by adding this amount to a server’s wage, it will also change their base hourly wage. The base hourly wage is used to calculate a server’s overtime pay rate, but with this new method of reporting, the base hourly rate could change daily.

As mentioned in our previous article, according to the IRS, for a payment to be considered a tip, it must meet the following factors:

• The payment must be made free from compulsion
• The customer must have the unrestricted right to determine the amount
• The payment should not be the subject of negotiation or dictated by employer policy
• Generally, the customer has the right to determine who receives the payment

If any of the above factors are missing, then there is doubt that the payment is a tip and may be considered a service charge.

IRS Rev. Rul. 2012-18 includes a couple examples to help clarify what may be considered a tip versus a service charge. One example is when a restaurant automatically adds an 18% charge to the bill of a party of six or more. This would be considered a service charge because it was added automatically as part of the restaurant policy and the customer did not make the payment free from compulsion. However, if the bill noted various tip amounts and the customer chose an amount to place on the tip line, then it would be considered a tip because the customer had a choice whether to leave an amount or leave it blank. Therefore, the customer was free from compulsion. The restaurant policy did not dictate the amount, and the customer and restaurant did not negotiate an amount. The customer generally determined who received the payment.

If you have any questions regarding the new tip and service charge rules and how to implement a strategy, please feel free to contact me at (805) 963-7811 or bforeman@bpw.com.