When Is a Tip Not a Tip? When the IRS Says So…

Here’s a tip: restaurants that tack a fixed charge on certain bills must begin withholding additional taxes on those amounts.

Known as “auto gratuities,” compulsory service charges paid by diners should be considered employer-paid wages—not tips—and treated accordingly for tax purposes. Law firm Pillsbury:

“Employers are required to collect income tax, employee social security tax and Medicare taxes on tips reported by employees… In contrast, collected service charges that are then distributed by the employer to employees are treated as wages subject to the normal reporting and withholding rules.”

That means that restaurants will need to begin withholding FICA (social security) taxes on those wages. How to tell the difference? Law firm Ford & Harrison:

“… four conditions must exist for a payment to be classified as a ‘tip’; the absence of any of the factors indicates that the payment may be a service charge. Those four requirements are:

  • the payment must be made voluntarily, without any compulsion;
  • the customer must be free to determine the amount of the payment;
  • the payment cannot be dictated by employer policy or be subject to negotiation; and
  • the customer must generally have the right to determine who is entitled to receive the payment.”

For example, writes Pillsbury:

“A restaurant policy of automatically adding an 18% charge to the bill of parties of six or more is a service charge because (i) the customer did not have the unrestricted right to determine the amount of the payment, which was dictated by employer policy; and (ii) the customer did not make the payment free from compulsion. On the other hand, a restaurant bill that includes sample calculations of different tip amounts (e.g., 15%, 18%, or 20%) but leaves the actual tip line blank is a tip because (i) the customer was free from compulsion to enter any amount on the tip line or leave it blank; (ii) the customer and the restaurant did not negotiate the amount nor was the amount dictated by restaurant policy; and (iii) the customer generally determined who would get the amount.”

Still not clear on the difference? You may have more time. Again, Ford & Harrison:

“Although Revenue ruling 2012-18 is retroactive, and in large part merely updates existing authority, the Announcement and the guidance memorandum state that, in limited circumstances, examiners should apply the Revenue Ruling prospectively only, to amounts paid beginning January 1, 2013, when determining whether an amount is a ‘tip’ or a ‘service charge.’ Those ‘limited circumstances’ are where the particular situation has not been addressed by prior guidance and where the employer involved needs additional time to ‘amend its business practices and make systems changes’ in order to comply.”

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