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Tip Reporting Rules

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The IRS Automatic Gratuity Ruling

Effective in January 2014, the Internal Revenue Service will classify an automatic gratuity—the policy of adding an automatic tip to the bills of large parties of diners—as a service charge instead of a tip. The IRS regards service charges as regular wages, which must be reported as payroll to the employees and subject to payroll tax withholdings.  This Revenue Ruling  was originally issued in June 2012 as part of an effort to update earlier tax policies on tips, but the implementation was delayed up to now so that restaurants and related businesses had more time to comply.

Before the new ruling was in place, IRS tips and service charge rules generally did not regard automatic gratuities as "regular wages." Many restaurants instituted the practice to lessen the possibility that their waiters were deprived of an appropriate tip when serving large parties.  This was particularly helpful to servers who depend on tips to supplement their minimum wage rate pay.

The new rules  require that restaurants need to determine the relative benefits and disadvantages of continuing a policy of automatic gratuities. When is a payment regarded as a tip or a service charge? The following  conditions would allow a payment to be classified as a tip:

  • 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.

If the above conditions are not met, for example, the bill for a party of eight might include an amount on the "tip line" equal to 18% of the price for food and beverages (the total includes this amount), if the restaurant  allocates this automatic gratuity to its employees, the IRS considers the amount a service charge, because "under these circumstances, the customer did not have the unrestricted right to determine the amount of the payment ...".  This service charge is therefore treated as non-tip wages, according to the new rules.

The impact to restaurants and employees who continue the practice of automatic gratuities  will be  additional paperwork and record-keeping related to payroll accounting; and  a hike in payroll taxes for both restaurants and servers.

What to do?

It is expected that large restaurant chains will opt  to discontinue the policy of automatic gratuities. The added time and expense involved in maintaining accurate records for tax purposes may make the practice prohibitive.  As an alternative, some restaurants  will  suggest tips amounts of 15%, 18% or 20% on all bills,  whatever the size of the party and  leave the tip line blank.  This will leave the patrons  choice of tipping more or less than these suggested percentages—or not tip at all.  This seems to be the most feasible option to most restaurants.

What do you need to tell your staff?

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 and debit cards and tips received from other employees under any tip-sharing arrangement.   You must inform them if you change your policy regarding automatic tips being added to a bill.