Understanding the Implications of 'Service Charge' versus 'Tip'
It is a given that in the restaurant industry, outside the quick-service segment, a lot of revenue received from customers is characterized as "tips" used to pay for the service provided. Over the years, however, in an effort to increase the amount and certainty of "tip" revenue, restaurateurs have adopted strategies that may be more akin to a "service charge" even though the revenue is still called a "tip."
For example, to ensure "tip" revenue from customers who historically do not leave sufficient tips, some restaurants would assess an "automatic gratuity" to larger parties (e.g., six or more patrons) or (perhaps unlawfully) on foreign tourists who may not be familiar with tipping conventions in the United States (e.g., that service is not included in the cost of the meal).
Whether these practices turn a "tip" into a "service charge," has several tax and wage-and-hour implications. This is not exactly late-breaking news; however, it seems to be a source of confusion among operators.
New Year, New Enforcement
Effective January 1, 2014, the IRS began enforcing new rules on what is a "service charge" and what is a "tip." Although the new rules were announced in June 2012, implementation was delayed until this year because of the resulting confusion and potentially negative effect on restaurants and other hospitality employers that use service charges to supplement servers' income.
This rule change affects the potential federal and state income/revenue taxes an employer may be obligated to pay, and also can affect the servers' employment tax obligation.
Many state and local tax authorities also treat "service charges" and "tips" differently for taxes imposed upon restaurants. Although those authorities may have their own definitions of those terms, in the absence of such a definition they are likely to follow the IRS guidance.
Because employees are deemed to receive their tips directly from the customer, even if they "pass through" the employer's processing of credit card charges or tip pooling arrangement, restaurant employers withhold the employee share of FICA (Federal Insurance Contributions Act) taxes on the reported tips from the hourly wages of the employee (other than tips).
As you most likely realize (I hope), the employer pays both employer and employee shares of FICA taxes in the same manner as the taxes on the employee's nontip wages and includes the reported tips on the employee's federal W-2 form, Wage and Tax Statement. The employer makes a current period adjustment on federal 941 form, Employer's Quarterly Federal Tax Return, to reflect any uncollected employee FICA taxes on reported tips. At the end of the year, the employer also reports any uncollected employee FICA taxes on the employee's W-2, Wage and Tax Statement. The employee must report these amounts as additional tax on the employee's federal 1040 form, U.S. Individual Income Tax Return (or other applicable return in the 1040 series).
If your accountant or attorney is not up to speed on the new rules, let him or her know that on June 25, 2012, the IRS issued Revenue Ruling 2012-18 for guiding employers and employees "regarding taxes imposed on tips under the Federal Insurance Contributions Act (FICA), including information on the difference between tips and service charges, the reporting of the employer share of FICA under section 3121(q) of the Code, and the section 45B credit."
While the ruling does indeed provide guidance on the employer's and employee's tax obligations (including what happens if an employee underreports tips), the most significant effect of the ruling is on its explanation of the difference between a "service charge" and a "tip." This determination can have a significant effect because many restaurant employers treat the "service charge" (i.e., "automatic gratuity" or "autograt") as if it were a tip, passing it on to the servers as reportable tips, and not recognizing it as taxable income to the restaurant.
Under the ruling, while all the facts and circumstances surrounding the payment must be taken into account, a payment will generally be deemed a "tip" if all of these four factors are present:
- 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.
It is pretty simple, right? We are familiar with the most common example of a "tip" under this definition. That is, the diner who receives a bill for the food and drink consumed, and then chooses to add an additional amount (e.g., 20 percent of the total food and drink) in recognition of the service. In that case, the customer had full discretion in deciding whether to leave a tip and the amount of the tip for the service. (As you also likely know, it is common nowadays to leave a consolidated tip for the server, bartender and busser, rather than different amounts as was common in the past; however, the customer normally does remain free to designate differing amounts for different services.
Compare this with the following example from the Revenue Ruling:
Restaurant W's menu specifies that an 18% charge will be added to all bills for parties of 6 or more customers. Customer D's bill for food and beverages for her party of 8 includes an amount on the "tip line" equal to 18% of the price for food and beverages and the total includes this amount. Restaurant W distributes this amount to the waitresses and bussers. Under these circumstances, Customer D did not have the unrestricted right to determine the amount of the payment because it was dictated by employer policy. Customer D did not make the payment free from compulsion. The 18% charge is not a tip within the meaning of section 3121 of the Code. The amount included on the tip line is a service charge dictated by Restaurant W.
In this example, the 18 percent charge would be a "service charge" that could not be passed on to the servers as a "tip" (i.e., subject only to the restaurant's obligation to pay and deduct FICA) and not recognized as income by the restaurant. Instead, if the employer passes the service charge through to its servers, the amount will have to be treated as wages. This will add additional recordkeeping burden on the restaurant and potentially raise the employer's FICA taxes. According to the IRS, however, the increase on the restaurant's FICA tax obligation should be minimal if employees have been fully reporting their tips.
In most restaurants, the 18 percent charge (in the IRS example) for larger parties is intended to address the fact that in many instances, large parties often leave little or no tips for the servers, even though larger parties are more work. Thus, the Revenue Ruling leaves the restaurant employer with a dilemma on how to continue ensuring servers of "tip" income in cases of large parties, banquets, catered events or other group service situations.
How Are Restaurateurs Responding to the Revenue Ruling?
It can be useful to see what the chains are doing. Many larger restaurant chains are doing away with the "autograt" service charge to avoid the additional recordkeeping and potential increase in FICA taxes. So how are restaurants collecting sufficient tip amounts to compensate their servers?
Darden Restaurants Inc., for example, announced that it was moving to a system of "suggested tips." That is, each bill would suggest tip amounts equaling 15 percent, 18 percent or 20 percent, but leave the tip line blank for the customer to fill in. In that way, the customer is free to leave any amount of tip, including no tip, but the customer is still prompted to leave a standard tip amount for the bill. This method of suggesting a tip was expressly approved in the Revenue Ruling.
While this method of suggesting tips may work for the typical dining situation and may even be helpful for large parties that ask to "split the check" at the conclusion of the meal, it does not provide the restaurant any "guarantee" that in fact a sufficient amount of tip will be left to pay for the service received.
Moreover, it is not particularly workable in situations such as banquets, catered events or similar "group service" situations in which the customer enters into an agreement in advance; for example, when a customer books an office holiday party with drinks, dinner and so forth. For such events, it is not always impossible, as the event is ending, to find someone with the "authority" to sign the bill or feel empowered to add an amount of tip for the service.
For example, the first client I worked with on this issue was an upscale franchisee that was focused on the fact that at many events in their banquet rooms, while there might be someone nominally in charge, by the time it came to settle up, that person was gone and no one was willing to sign. While the business still was paid for the meal, there was not a reliable way to ensure a gratuity. The suggestions assume that the on-site person has the authority to add a tip, and this is not always the case, particularly as the person booking the event may not want to turn over spending authority carte blanche to someone on site whose judgment might become impaired over the course of the event.
There are several ways to address this issue. First, as should be done for any event, make sure to identify the host or on-site contact at the very beginning of the service and ensure regular, repeated contact between the server (or lead server) not only to ensure the host/contact that his/her party is receiving superior service and care, but to verify that the host/contact will not leave prior to the presentation of the bill for signature. Then, as with the normal dining situation described earlier, follow the approach of having suggested tip percentages for the host/contact to choose from as well as a blank for a different amount. So that the host/contact does not feel surprised when asked to provide a gratuity, it should be clear when the event is booked that service is not included in the price.
While it remains to be seen whether the IRS will approve, there is case law outside the restaurant industry suggesting that a "predetermined" or "standard" tip is permissible, provided that at the time the service is provided or the bill paid, the customer can change the amount of the tip. Therefore, although the IRS has not explicitly ruled on this procedure following the Revenue Ruling, some restaurateurs are including in their banquet/catering contracts a set tip amount or (following the example of suggesting tip amounts) allowing the customer to put a tip amount, expressly reserving to the customer the opportunity to change the amount at the time of service or when the bill is settled. Although there is again no "guarantee" that the customer will pay for the service provided, the expectation is that a satisfied customer at time of settlement will pay the total amount of the bill and not make any changes in the amount of tip.
What Is the Effect On the Tip Credit?
The so-called "tip credit" was first introduced by Congress in 1966 through amendments to the Fair Labor Standards Act (FLSA). Congress has repeatedly amended the tip credit -- in 1967, 1974 and again in 1996 -- and the Department of Labor has provided guidance through regulations and opinion letters, leading us to the current version of the rule. Presently, the tip credit allows employers to count a portion of an employee's tips as a "credit" toward the federally mandated minimum wage.
As a result, an employer may pay an employee a cash wage less than the minimum wage, so long as the employee's total income after tips is over the minimum wage and so long as the employer otherwise complies with the tip credit rules and regulations. Based on the current FLSA tip credit rules, an employer may pay tipped employees a cash wage of $2.13 an hour and use a tip credit of $5.12 an hour to satisfy the federally mandated $7.25 minimum wage. Not all states permit the use of the "tip credit" or require a higher minimum cash wage. If you take advantage of the tip credit, it is necessary to comply with both federal and state law.
The FLSA regulations describe the general characteristics" of a tip as:
A tip is a sum presented by a customer as a gift or gratuity in recognition of some service performed for him. It is to be distinguished from payment of a charge, if any, made for the service. Whether a tip is to be given, and its amount, are matters determined solely by the customer, who has the right to determine who shall be the recipient of the gratuity.
While it is not unusual for governmental agencies to have differing and sometimes conflicting definitions for the same term, in this instance there is a significant overlap between the IRS definition of a "tip" and the definition under the FLSA. Therefore, if there is any question as to whether an "autograt" was a tip under the FLSA for purposes of the tip credit, that doubt may be resolved as a "no" in light of the IRS Revenue Ruling. That is, even if the employer passes through amounts received pursuant to an "autograt" function, it will likely be treated as a "service charge" that cannot be applied toward the tip credit.
The effect of the IRS Revenue Ruling, however, goes beyond simply providing additional guidance on what constitutes a "tip." The steps restaurants have taken over the years to "guarantee" tips sufficient to cover the amount taken as a tip credit are no longer viable. Thus, while the employer may continue to pay servers (and in some states such as New York may be required to pay servers) amounts charged for service as a way to ensure they receive sufficient income, under FLSA, those amounts cannot be applied toward the employer's minimum wage obligation because they are not a "tip" within the meaning of the FLSA. That said, the strategies addressed earlier for meeting the IRS definition of "tip" (e.g., suggesting tip amounts or writing an anticipated tip into a banquet contract) should help generate tips (under the FLSA) to cover the tip credit being taken.
A New Level of Business and Legal Risk
While the IRS Revenue Ruling has no doubt caused some confusion about what strategies can be followed to generate sufficient tip income to properly compensate service staff, there are ways to comply. Unfortunately, the new rules introduce a new level of business and legal risk. That risk can be reduced by reviewing your policies and procedures for tips, gratuities, labor or service charges and the like to determine whether the revenue they generate is being treated correctly for tax and wage-and-hour compliance.
ADDITIONAL SOURCES:
National Restaurant Association Tip Credit Employee Notice Requirements
A key requirement for taking the tip credit is notice to employees. To help with the confusion over the notice required of employers, the regulations were amended in 2011 to provide concrete examples of the types of information employers must provide employees about the tip credit. For example, the updated regulations state that employers should inform employees of the amount of cash wages to be provided to the employee; of the amount by which wages are increased through the use of the tip credit; and that employees are entitled to retain all tips.
Even after the new amendments, however, employers need not provide this information in writing. Of course, putting it in writing and obtaining an employee's written acknowledgment of receipt would help prove that the information was provided. The National Restaurant Association has developed two sample notices that can be used for this purpose, which can be obtained from the association's website. Sample A is for those who do not require tip pooling, while Sample B is for those who do not.
