The IRS’ New Definition of Tips

Automatic Gratuity and Services Charges are not Tips

Service Charges are not Tips

Restaurant payroll will be a little trickier starting January 2014 thanks to a new IRS rule. Rev. Rul. 2012-18 reclassifies automatic gratuities as non-tip wages, or service charge income, taxable as regular wages. It defines tips as something given without compulsion and with an unrestricted right to determine the amount, which excludes automatic gratuities. This applies to commonly assessed 18 percent automatic amounts added to restaurant bills for large tables as well as bottle service charges, room service charges, contracted luggage assistance charges and delivery charges for pizza and grocery deliveries.

The new rule affects restaurant payroll for employers who add automatic gratuities to ensure restaurant workers are compensated for the extra time and effort required to serve and clean up after large parties. The IRS now requires restaurants to track automatic gratuities as service charge income and include it in W-2 wages. In addition, as it’s not defined as a tip, automatic gratuities can’t be used toward employers’ tip credit to reduce their minimum wage obligation, which adds a direct cost and increases employers’ tax burden.

Effective January 1, 2014

The new rule for restaurants and other industries that earn tips becomes effective January 1, 2014, following an extension from the original ruling in 2012. The extension was intended to give employers time to make adjustments in accounting, payroll practices and systems to comply. Some solutions include keeping automatic gratuities and adjusting computer accounting and payroll systems and budgets to handle new calculations and increased costs, or stopping the automatic gratuities and developing better communication with customers about tipping percentages in service situations requiring more effort for restaurant staff.

The IRS Definition of “Tip”

The updated legal definition of “tip” includes four factors:

  • The payment must be free from compulsion
  • The customer must have the unrestricted right to determine the amount
  • The payment should not be subject to negotiation or dictated by company policy
  • The customer generally has the right to determine who receives the payment

Increased Liability

The new rule creates increased possibility of restaurant payroll being investigated by the IRS, the Department of Labor, and plaintiff’s attorneys for noncompliance and wage law violations. This should prompt restaurants to be very careful about how they pay and account for automatic gratuities and administer payroll.

To reduce potential liability, many restaurants are dropping automatic gratuities in favor of adding “suggested tip ranges” to checks and menus to remind customers of tipping standards without adding to their payroll processing burden.

Food for Thought

Pete Wells, a New York Times restaurant critic, would like to do away with tipping altogether, saying it’s outdated and fraught with errors and abuse. Heather Long, writing for theguardian.com, begs to differ. She thinks the IRS going after tips is just “one more reason it’s crap to be a waiter,” and worries that the new rule is going to hurt servers on the lower end of the tipping income scale at family and chain restaurants. She quotes a former Applebee’s waitress who claimed “Tips are not optional. They are how waiters get paid in America,” worrying that reclassifying automatic gratuities as non-tip wages chips away at an already low base salary for servers.

This new IRS tip rule presents some challenges for employers to ensure compliance and most will need to make changes to payroll, accounting and point of sale systems (POS) to ensure automatic gratuity amounts are classified correctly. A good way to do this is by outsourcing payroll processes to a company that can extract the information directly from POS to payroll.

Contact us to find out how PAYDAY is handling the upcoming change and how we can help with compliance.

 

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