Restaurants that currently charge an automatic percent service charge for large parties (ie 18%) will no longer be able to treat these amounts as tips in 2014, according to a recent IRS ruling. The IRS clarified that service charges paid on or after Jan. 1, 2014, will be considered part of employee wages and subject to withholding and reporting requirements.

As a result of this change in classification, employers will not only lose the benefit of having these amounts included in their FICA tip credit calculation, but such payments will be part of the tipped employees’ hourly wages. The ruling also determined that to the extent any portion of a "service charge” is distributed to an employee, it is wages for FICA tax purposes.

When is a tip a tip?

The ruling provides that a tip satisfies the following four factors:

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

When is a tip really a service charge?

The ruling provides the following illustration of an alleged tip that is actually a service charge: A restaurant’s policy of adding an 18 percent service charge to the bill for parties of six or more is a service charge rather than a tip because the customer did not have the unrestricted right to determine the amount of the payment – it was dictated by the restaurant’s policy – and the customer did not make the payment free from compulsion.

Can I put a suggested tip amount on the receipt?

A bill with sample calculations of different tip amounts, where the actual tip line and total amount line is left blank, is truly a tip.

How do you ensure a tip is really a tip?

To ensure a tip is not actually a service charge according the IRS, make sure the tip line and total amount on any bill is left blank for the customer to complete in his or her discretion. While a restaurant may include sample calculations on the bill of different tip amounts (e.g., 15% = X), these must be clearly identified for reference purposes only so the IRS does not determine a certain amount is being mandated from the customer.

Do not print menus that say an automatic gratuity will be added to the bill.

What about auto-gratuities for banquets?

Although a service charge on a restaurant bill will most frequently be encountered, restaurants should be cautioned that auto-gratuities paid for catering, banquets, weddings and other amounts mandated by employer policy will be covered as well.

Do I have to pay sales tax on the service charge?

Mandatory service charges are part of the cost of the food and therefore subject to sales tax. Tips, which are discretionary, are not part of the cost and therefore not subject to sales tax.

What difference does it make whether a payment is a tip versus a service charge?

• Service charges are considered wages, and, therefore, not eligible for the FICA Tip Credit (The 45B Credit). For many years, restaurants have benefited from being allowed to apply a general business credit toward a portion of the employer’s social security and Medicare taxes paid on tips in excess of the federal minimum wage as of Jan. 1, 2007 (i.e., $5.15 per hour). As the ruling makes clear that service charges are not tips, they cannot be included in the tip amount that social security and Medicare taxes are paid on, which takes some tax credit off the table for restaurants. This credit is claimed on Form(s) 8846 and 3800.
• Tips and wages are reported on separate lines of the quarterly payroll tax return (Form 941). Incorrectly characterized service charges should be recharacterized and an adjustment made to Form 941 via tax report Form(s) 4666 and 4668.
• When completing Form 8027 (Employer’s Annual Information Return of Tip Income and Allocated Tips), service charges distributed to employees and the respective sale should not be included on the form.
• Some business may have to change their automated or manual reporting systems to comply with this distinction.
• Employers who pay out a portion of the automatic gratuities or service charges to employees may have to recalculate its employees’ overtime rates. The ruling considers these payouts to be wages, rather than tips, so that money counts toward the employee’s regular rate of pay and should be factored into the overtime calculation.

What if I make a mistake?

Taxpayers are required to account for service charges separately from tips. Business systems, whether manual or automated, need to be configured in such a way that these amounts can be accounted for in the normal course of business.

If the IRS audits your business and finds that amounts have been misclassified as tips, they will propose adjustments to Form 941 which in turn may require a change to the employer credits for FICA taxes paid reported on Form 8846. Any mistakes will result in the imposition of penalties and interest.

Businesses should ensure that they are complying with these rules. The fact that the IRS has recently issued a ruling in this area indicates that increased scrutiny from the IRS may be coming in the near future.