As reported in the March issue of PMQ, the Internal Revenue Service (IRS) now classifies an automatic gratuity—that is, any required tip added by restaurant management to customers’ bills—as a service charge instead of a tip, and these charges will constitute taxable wages for payroll tax purposes. So what does this mean for restaurant operators? In this article, we’ll look at the ruling in some detail and explain how restaurateurs can remain in good standing with the IRS and help their employees do the same.

The IRS ruling (Revenue Ruling 2012-18) on automatic gratuities isn’t exactly new—it was first issued in June 2012 in an effort to update earlier tax policies on tips, specifically Revenue Ruling 95-7. But implementation was delayed to give restaurants and other businesses more time to comply. The ruling earned a great deal of media coverage after officially taking effect in January 2014.

So what has changed? Since 1994, restaurateurs have been able to characterize mandatory automatic gratuities as “tips” for tax purposes, thus avoiding paying FICA tax on those amounts. This had an obvious advantage for both employers and employees and led to widespread use of this method of payment. The practice helped ensure that employees would receive appropriate tips when serving large parties (such as tables of six or more people) while also reducing tax-related paperwork for restaurant operators.

In 2012, however, the IRS released Revenue Ruling 2012-18, which stated that it would begin to consider automatic gratuities to be wages subject to normal withholding rules. The IRS applied its traditional test for determining whether a payment was a “tip,” which includes looking at whether the customer decides the amount of the payment and who receives the payment. In this case, because automatic gratuities are mandatory, the IRS will consider them to be service charges—and thus taxable wages—instead of tips. Additionally, mandatory delivery fees—such as those charged by many pizzerias—will also be considered service charges and will be taxed accordingly.

Defining a Tip

In the case of restaurant employees, exactly what makes a tip a tip?  The IRS uses the following criteria:

  • The payment must be given by customers voluntarily and free from compulsion.
  • Customers must have the unrestricted right to determine the amount of their tips.
  • The payment should not be the subject of negotiation or dictated by employer policy.
  • The customer has the right to determine who receives the tips.

The IRS does not consider automatic gratuities, such as a service charge of 18% on parties of six or more customers, to be tips because they don’t meet the above criteria. Therefore, the 18% automatic gratuity is considered a service charge dictated by the restaurant, and any money disbursed to employees from this charge will be treated as wages for FICA tax purposes.

Assessing the Impact

So how will this ruling affect your everyday business? If your restaurant continues to add automatic gratuities to checks, you can expect the following:

  • More paperwork and record keeping to differentiate tips and service charges, including documentation to substantiate why a payment is treated as a tip or as a service charge
  • An increase in payroll taxes for both restaurants and servers
  • A reduction of tip credit due to payments classified as service charges, not tips

Operators can take advantage of an IRS program called the Tip Rate Alternative Commitment (TRAC). Under TRAC, employers must take steps to increase tip reporting compliance by employees, and in exchange the IRS won’t demand more FICA taxes from the employer in the event of tip underreporting. If employees underreport their tip income, the IRS will examine only the employees, not the employers. Under the terms of the TRAC agreement, employees must report all tips they receive over each calendar month in written statements submitted to the employer, and procedures must be in place to ensure the tip reports’ accuracy. Operators must also maintain a quarterly educational program that trains newly hired employees about tip reporting and periodically updates existing employees about their tip reporting obligations. Operators must also comply with federal tax requirements regarding filing of returns, paying and depositing of taxes, and maintaining records related to payroll.

Tipped employees must report tips to employers using Form 4070, Employee’s Report of Tips to Employer, and Form 4070A, Employee’s Daily Record of Tips. As the employer, you will not be held responsible for verifying the accuracy of the amount of tip income your employees report to you. Rather, the burden of proof lies with the employee. If the employee fails to report tips of $20 or more per calendar quarter to the employer, the latter may be held liable only for the employer’s portion of FICA.

Additionally, automatic gratuities or service charges will be subject to sales tax in many states, whereas tips will not be included in a taxable sale. While sales tax is not an employer or employee expense, it does drive up the cost to the customer to dine at your establishment.

In the final analysis, restaurant operators will have to make a decision: Will they continue adding automatic gratuities to their checks or get rid of them? Treating these gratuities as taxable service charges could make it harder to find waitstaff willing to work large parties, and the service charges will have to go through the payroll process, meaning operators can’t cash out their servers on a daily basis. Darden Restaurants, which owns Olive Garden and Red Lobster, has reportedly ditched automatic gratuities at many of its locations and now simply lists suggested tip amounts on a separate part of the check instead. Other chains are expected to follow suit.

With this in mind, operators will need to sit down and discuss the new ruling and its implications with their employees if they haven’t already done so. Let them know that the IRS mandated the change and that ignoring the law could have dire consequences. Seek employees’ input before you implement any changes to your restaurant’s policy, but, in the end, the decision, of course, will be yours and only yours to make.

Michael J. Rasmussen and Laura Hanlon are certified public accountants who specialize in the restaurant industry.