Effective Jan. 1, 2014, the Internal Revenue Service (IRS) will recognize automatic gratuities, a percentage automatically added to a restaurant bill, as a service charge, rather than a tip. The IRS ruling on automatic gratuities isn’t new. This was the result of a June 2012 tax ruling that was delayed to give restaurants and related businesses more time to comply.
The IRS regards service charges as regular wages which must be reported for payroll tax withholding under the Federal Insurance Contributions Act. Additionally, any portion of a service charge that is distributed to an employee is considered part of the wage for FICA tax purposes. Therefore, where automatic gratuities are now considered service charges and service charges are considered wages, the money left automatically for restaurant employees will now be considered part of the employee’s wages.
The following shows how the ruling defines a payment as a tip, rather than a service charge:
• Payment must be made free from compulsion.
• The customer has the unrestricted right to determine the amount.
• Payment should not be subject to negotiation or dictated by employer policy.
• Generally, the customer has the right to determine who receives payment.
The IRS urges employers to remind their workers that “all cash tips received by an employee are wages for FICA tax purposes and, therefore, must be reported to the employer.” Cash tips specifically include the tips servers receive from customers, tips charged on credit cards, “and tips received from other employees under any tip-sharing arrangement.”
Why does it matter 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 businesses 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.
So how does this work in practice?
Let’s say an employee works nine hours in one day, and is thus entitled to one hour of overtime pay. If you have paid him/her a portion of the automatic gratuities he/she earned that day, that amount counts toward the overall wages he/she earned that day and must be factored into the calculation of his/her regular rate of pay (i.e., total wages ÷ 8 hours). In turn, this is the regular rate of pay that would need to be used to determine his/her overtime pay rate (one-and-a-half times his/her regular rate of pay) for the one hour of overtime.
If the same employee works more than 40 hours in a week and is paid a portion of the automatic gratuities he/she earned that week, the amount of automatic gratuities he/she was paid is considered part of his/her wages. Accordingly, his/her total wages for that week, including the automatic gratuity amount, should be divided by 40 hours in order to determine his/her regular rate of pay. Again, this is the regular rate of pay that must be used to determine his/her overtime pay for time worked in excess of 40 hours during the week.
Finally, 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 would likely be covered as well.
Employers that fail to calculate overtime using a regular rate that includes any portion of service charges paid out to the employees risk future class action litigation for unpaid overtime.