The IRS ruling on automatic gratuities isn't actually new, having been issued in June 2012 as part of an effort to update earlier tax policies on tips. Implementation was delayed up to now, however, so that restaurants and related businesses had more time to comply.
Mandatory gratuities are considered income to the restaurant. Most operators are familiar with this tax treatment when assessing a labor charge for banquets, but some are not aware that this concept extends to a mandatory tip amount or service charge.
A service charge is an amount automatically added to a customer’s bill by management. The IRS lists four factors, all of which must be present in order for the customer’s extra payment to be deemed a tip and not a service charge:
1. The customer’s payment must be made free from compulsion;
2. The customer must have the unrestricted right to determine the amount;
3. The payment should not be the subject of negotiation or dictated by the employer policy; and
4. Generally, the customer has the right to determine who receives the payment.
IRS gives the following examples to distinguish when a gratuity left by the customer will be considered a tip or service charge:
EXAMPLE 1: A restaurant’s menu specifies that an 18 percent gratuity will be added to all customer bills. A customer’s bill for food and beverages includes an amount on the “tip line” equal to 18 percent of the price for food and beverages and the total includes this amount. The restaurant distributes this amount to the servers and bus-persons. Under these circumstances, the customer did not have the unrestricted right to determine the amount of the payment because it was dictated by employer policy and the customer did not make the payment free from compulsion. The amount included on the tip line is a service charge dictated by the restaurant.
EXAMPLE 2: A restaurant includes sample calculations of tip amounts beneath the signature line on its charge receipts for food and beverages provided to customers. The actual tip line is left blank. A customer’s charge receipt shows sample tip calculations of 15 percent, 18 percent and 20 percent of the price of food and beverages. The customer inserts the amount calculated at 15 percent on the tip line and adds this amount to the price of food and beverages to compute the total. Under these circumstances, the customer was free to enter any amount on the tip line or leave it blank; thus, the customer entered the 15 percent amount free from compulsion. The customer and the restaurant did not negotiate the amount nor did the restaurant dictate the amount. The customer generally determined who would get the amount. The amount the customer entered on the tip line is not considered a service charge.
If the gratuity is deemed to be a service charge rather than a tip, under federal law, service charges:
1. belong to the establishment
2. become a part of the establishment’s gross receipts
3. must be considered as income to the employer, and
4. may be retained entirely by management or distributed to employees in any amount management chooses.
Service charges that get distributed to employees are treated as wages under federal law. Distributed service charges may be used to help employers meet their obligation to pay employees the minimum wage. However, a compulsory service charge cannot be counted towards the tip credit.
Under the DOL regulations restaurants that automatically add a gratuity, for example, for large parties or catered events, cannot take a tip credit for the mandatory gratuity the establishment receives, even if management passes the gratuity on to employees. Instead, the mandatory-gratuity receipts are considered part of the employer’s receipts. The money paid from those receipts to employees is considered wages rather than tips.
Any portion of a mandatory gratuity charge that is retained by the employer is subject to sales tax.
It is important to note that restaurants should clearly inform guests of service charges and the amount of the charge before the guest orders, either by a conspicuous notice on the menu or by some other means.