Among the issues restauranteurs face is whether or not to include automatic gratuities on guest checks. A common automatic gratuity is a charge ranging from 18%-20% on parties of six or more guests. After much debate, the IRS determined – in Revenue 2012-18 – that automatic gratuities are service charges–not tips. This ruling, which went into effect on January 1, 2014, increased the paperwork burden and payroll tax commitment for restaurant owners. Service charges are treated as regular wages, to the extent they are distributed to employees. Additionally, the employer must withhold employee income tax and the employee’s share of FICA (Social Security and Medicare) taxes, and pay the employer’s share of FICA taxes related to these service charges.
While both tips and service charges are taxable income to the employee, the classification of a payment as a service charge has significant implications to the employer:
- Service charges are not eligible for the FICA Tip Credit. This credit, under the Internal Revenue Code, allows restaurants and other food and beverage service businesses to claim a tax credit based on the employer’s share of FICA taxes paid with respect to cash tips, but not service charges. The credit is not allowed to the extent tips are used to meet the federal minimum wage rate.
- Service charges are subject to sales tax, while tips are not subject to sales tax.
- Service charges may increase overtime pay, paid sick leave and other paid time off, depending on the law in the relevant jurisdiction. This is because service charges distributed to employees may have to be included in employees’ hourly rates when calculating these items.
- Additional administrative costs associated with tracking tips and service charges differently.
Due to the increased paperwork burden and additional administrative costs mentioned above, many restaurant owners prefer tips over service charges.
According to current IRS guidelines, a payment ordinarily qualifies as a tip if it meets these four characteristics. First, the payment is made free from compulsion. Second, the customer has the unrestricted right to determine the amount. Third, the payment is not subject to negotiation or dictated by the policies of the employer. Fourth, the customer has the right to determine who receives the payment. The absence of any of the above factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge.
As discussed above, the IRS now classifies automatic gratuities as service charges. However, if restaurant owners move away from automatic gratuities and instead include suggested tip amounts printed below the signature line, these usually qualify as tips, as long as the customer is free to enter any amount on the tip line – or leave the line blank.
The topic of automatic gratuities and suggested tips is complex, with pros and cons for both the employee and the employer. It is important for restauranteurs to understand all the facts before selecting the method that best suits their business.