Tax on Gratuity vs. Service Charge: A Primer for Small Business Owners
If you own, operate, or manage a business in a service industry, it's important to understand how to calculate tax on a gratuity vs. service charge. As industries continue to evolve (enter companies such as Uber, Lyft, and Amazon Flex), employees from a wide variety of industries may receive a portion of their pay in tips or service charges. This adds a layer of complexity to tax calculations and can present a number of payroll challenges for employers.
Failure to understand this important distinction between gratuity and service charges can result in fines, lawsuits, and other problems for a business. To help avoid these issues, review this primer on how to calculate tax on gratuity vs. service charges.
Tips vs. service charges: Understanding the differences
The IRS has specific reporting and taxation rules for tips and gratuities, defining tips as:
- Cash received directly from customers;
- Extra money from customers through electronic payment, including credit cards, debit cards, and gift cards;
- The value of any non-cash perquisites, such as tickets or other items of worth; and
- Amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip-sharing arrangements.
If money or valuables received from customers fall into the above categories, it must be treated as a gratuity and taxed according to the IRS regulations for gratuity. Tips must also be given freely (without coercion) and the customer giving the tip must be able to determine who receives the payment.
Service charges, on the other hand, are any extra fees or predetermined charges added to a customer's bill. Examples of service charges include:
- Automatic gratuities (usually 18 percent or more) attached to large dining parties;
- Banquet event fees;
- Cruise-trip package fees;
- Hotel room service charges; and
- Bottle service charges by nightclubs and restaurants.
Because some employers keep a portion of service charges, the IRS considers automatic gratuities to be revenue for the business and the dollars distributed to staff as non-tip wages. This means that service charges are treated as regular wages for tax purposes.
Reporting requirements for gratuities
The IRS has specific reporting requirements for employee tips that must be followed by employees and business owners alike. Employees are responsible for reporting tip income to their employer, specifically all cash tips received, except for the tips from any month that total less than $20. Employees aren't required to report non-cash tips from customers, but both cash and non-cash tips count toward workers' gross annual income and are subject to federal income taxes. Indirectly tipped staff — e.g., table bussers and cooks — who share customer bonuses with tipped employees must also report tips to their employer.
Employers are required by the IRS to keep records of employee tips in order to withhold income taxes, social security, and Medicare taxes based on wages and tip income received. Employers are also required to pay their share of social security and Medicare taxes based on the total wages they pay to tipped employees, as well as the reported tip income.
Reporting requirements for service charges
Since service charges are treated as regular wages for employees, they fall under the same reporting and withholding requirements as other regular wages. These federal reporting requirements are outlined in Publication 15, The Employer's Tax Guide. Some states also have specific reporting requirements for businesses, so owners should take care to research any applicable revenue reporting requirements for states in which they operate.
Tax on gratuity vs. service charge
For service-based businesses where tipping is routine, employers can qualify for the FICA tip credit. This credit can potentially save employers hundreds or even thousands of dollars every year, but it only applies to tipped wages, not service charges. Falsely categorizing service charges as tipped wages in an attempt to increase this credit can end up costing the business much more in fees and penalties, so accurate calculation and categorization of extra funds paid to employees is critical.
Since service charges are categorized as regular wages for tax calculation purposes, employers are required to deduct payroll taxes before distributing to employees. Conversely, withholding is not required in advance when distributing tipped wages.
Tip and service charges can complicate payroll taxes. Use a reputable payroll provider to ensure that your business receives maximum benefit from tax credits while avoiding unnecessary fines or penalties from miscalculating gratuity or service charges.