The IRS recently released a series of guidance on the tax treatment of tips with Rev. Rul. 2012-18 and it could have an impact on your bottom line and tip reporting systems. The key takeaway is how the IRS is distinguishing between tips and service charges.
To determine if a payment is a tip, rather than a service charge, the IRS cites the following four 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; and
- Generally, the customer has the right to determine who receives the payment.
If any of the above factors is missing, there is doubt that the payment is a tip. These factors are not new, however the IRS has recently alerted its agents to actively look at this issue during examinations, instructing them that the employer’s characterization of a payment as a tip is not determinative.
An example illustrating the distinction between a tip and service charge: A restaurant policy of automatically adding an 18% charge to the bill of parties of six or more is a service charge, whereas a bill with sample calculations of different tip amounts (e.g., 15%, 18% or 20%), where the actual tip line is left blank, is a tip.
Why does is matter whether a payment is classified as a tip versus a service charge? Service charges are considered wages and therefore not eligible for the FICA Tip Credit, potentially taking money off your table. In addition, tips and wages are reported on separate lines of the quarterly payroll tax return (Form 941). Some businesses may have to change their automated or manual reporting systems in order to comply with this distinction.
In addition to restaurants, the IRS is looking out for auto-gratuities paid by customers for catering, banquets, weddings, transportation, baggage handling and other amounts dictated by employer policy. Rev. Rul. 2012-18 is effective immediately and applicable retroactively. However, under very limited facts and circumstances, it may be applied prospectively.
The rest of the guidance in Rev. Rul. 2012-18 provides other questions and answers relating to how tips are reported, how FICA taxes are paid and the employee and employer liability for unreported tips. If you have any questions or concerns on tip reporting please contact me at [email protected].