Most employers are familiar with the basics. A tip is a voluntary amount of money a guest leaves for an employee over the amount due for the goods sold or services rendered. For example, if you dine alone at a restaurant, you have the option to leave your server a tip in any amount. An automatic gratuity is a fixed percentage of the bill that a restaurant charges to larger parties. Thus, if you dine out with eight of your friends, you will likely be required to leave a certain percentage of that bill as an automatic gratuity. A service charge is an amount agreed-upon in advance by a venue for services provided that is usually in connection with large pre-planned events. An example of this would be a company party for a few hundred employees and guests which requires a signed contract that binds the employer to pay a service charge for the event. In each of these scenarios it may appear that the sum of money provided by the customer is just a variation of a “tip.” However, service charges and automatics gratuities are treated differently than tips for tax and other purposes as explained more fully below.
I. MANDATORY SERVICE CHARGES ARE TREATED AS WAGES
A. Tax Treatment by the IRS
The Internal Revenue Services (IRS) Revenue Rule 59-252 provides that the payment of a fixed charge imposed by a venue that is distributed in whole or in part to its employees who render services (such as a waiter, busser, or bartender) is a treated as a “service charge” and is not a tip. In practice, this means that the service charge subsequently distributed out by the employer to the employee is treated as non-tip wages for FICA tax purposes.
The IRS provides a list of factors to examine in determining whether a payment is a tip or service charge. The absence of any one of these items “creates a doubt” that the payment is in fact a tip, and instead “indicates that the payment may be a service charge”:
- The payment must be made free from compulsion.
- The customer has the unrestricted right to determine the amount.
- The payment should not be subject to negotiation or dictated by employer policy.
- Generally, the customer has the right to determine who receives payment.
Service charges, as non-tip wages, are subject to social security tax, Medicare tax and federal income tax withholdings. Moreover, the employer is precluded from using these service charges when computing the credit available to employers under section 45B of the Internal Revenue Code, because these amounts are not considered to be tips. Common examples of service charges in service industries are:
- Large party charge (restaurant)
- Bottle service charge (restaurant and night-club)
- Room service charge (hotel and resort)
- Contracted luggage assistance charge (hotel and resort)
- Mandated delivery charge (pizza or other retail deliveries)
B. Overtime Issue in California
According to California’s Department of Industrial Relations, a mandatory service charge is an amount that a customer is required to pay based on a “contractual agreement” or a “specified required service amount listed by an establishment.” This often takes place when a customer contractually agrees to pay an additional percentage charge of the cost of the party when planning an event. These charges are considered as amounts owed by the customer to the establishment; they are not gratuities voluntarily left for the employees.
Therefore, when an employer distributes all or part of a service charge to its employees, the Department of Industrial Relations explicitly provides that because this distribution is at the discretion of the employer, it is considered a bonus which must be included in the regular rate of pay for an employee when calculating the proper overtime payments. This differs from the treatment of a true “tip”, which is voluntarily left by the customer and is not being provided by the employer, and is thus not considered part of the employee’s regular rate of pay when calculating overtime.
II. AUTOMATIC GRATUITIES ARE TREATED AS WAGES
A. Tax Treatment By The IRS
Beginning in January 2014, the IRS changed its policy to treat automatic gratuities —which are forced tips patrons are required to pay—like service charges that would need to be reported to the IRS for payroll tax withholding. This is because the customer is not considered to have had the “unrestricted right to determine the amount” of the payment.
B. Overtime Issue In California
Automatic gratuities are treated like service charges for overtime purposes. This means that an hourly employee’s regular rate of pay can vary from week to week depending on the amount of earnings paid to the employee from automatic gratuities. This can pose complications for payroll purposes and expose an employer to liability if the calculations turn out to be incorrect.
Wage and hour laws are detailed and complex, and can vary from federal to state and from state to state. The rules are also constantly being revised by new laws, advisory opinions, and case law. Accordingly, employers should seek the further advice of employment counsel before finalizing any decision to change or implement new tipping, service charge, or automatic gratuity procedures.
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