Beginning in 2014, the IRS is changing the way restaurants treat service charges they add to customers’ bills. A service charge is usually a
required tip amount that restaurants add to the bill of large parties. For example, a restaurant may add a 18% required tip to a bill of a party of 10 or more people.
Restaurants are currently treating service charges as tips and not as wages. By doing this, they are leaving it up to the employee to report the service charges as income (i.e., some of these service charges may go unreported by employees). Restaurants are also claiming the tip tax credit on the amount of FICA taxes they are paying on service charges. The tip tax credit can be a substantial tax benefit for restaurants.
The IRS issued new guidance in 2012 that is taking effect January 1, 2014 that will require restaurants to treat service charges as wages, and not as tips. By doing this, restaurants will be required to track the service charges paid to employees (and not rely on the employee reporting the service charges as tips). Restaurants will also have to withhold taxes from the service charges.
Additionally, treating the service charges as wages will affect the hourly wage earned by employees. Finally, since the service charges are classified as wages, the FICA taxes paid on service charges will no longer qualify for the tip tax credit.
There is a way to avoid service charge treatment. To be classified as a tip, and not as a service charge:
- 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.
Example: Euro Restaurant automatically adds an 18% gratuity to bills of parties of 10 or more. On the bill, the tip line is automatically filled in with an amount equal to 18% of the food and beverage charge. Euro Restaurant distributes the service charge to its wait staff and bussers. The service charge will be treated as wages because: the payment was made under compulsion because it was required, the customer did not have the right to determine the amount, the payment was dictated by employer policy, and the customer did not have the right to determine who would receive the tip.
A technique some restaurants are using to avoid the service charge treatment is to suggest (and not require) tip amounts.
Example: Asia Restaurant does not require a service charge to bills of large parties, but they do suggest either a 15%, 18%, or 20% tip amount. The tip amount at each percentage level is listed on the bill. Customers are free to use any of the suggested tips, tip based on their own rate, or not tip at all. Under these circumstances, any amount the customers fill in the tip line will be treated as tips and not as wages. This is because: the payment was not made under compulsion—the restaurant only suggested a tip amount. The customer was free to determine what amount would be tipped. The payment was not dictated by restaurant policy.
It is expected that most restaurants who charge a required service charge will stop doing so and instead only suggest tip amounts.
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