How the IRS Automatic Gratuity Ruling Impacts Restaurants and Employees

Beginning 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 for payroll tax withholding.

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.

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 (typically considered tables of six to eight people or more). This was particularly helpful to servers who depend on tips to supplement their minimum wage rate pay.

As Revenue Ruling 2012-18 goes into effect, restaurants will 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 shows how the ruling defines a payment 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.

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 U.S. federal tax code.

What's the likely impact for restaurants and employees? Possible consequences for employers who continue the practice of automatic gratuities include (1) additional paperwork and record-keeping related to payroll accounting; and (2) a hike in payroll taxes for both restaurants and servers.

What do employers need to tell their 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."

The soon-to-be-implemented changes in tax policy will have a minimal effect on a restaurant's payroll taxes, the IRS says, if all tip income is accurately reported to employers. "If all tipped employees report 100 percent of their tips, the additional FICA [payroll] tax burden on the employer should be negligible," an online IRS Q&A states. "Changing the characterization from reported tip wages to non-tip wages ... should not have a tax impact on the employer."

The future of automatic gratuities

Experts say most 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.

According to a recent article in The Wall Street Journal, Darden Restaurants Inc. (owner of Olive Garden, LongHorn steakhouse and Red Lobster) plans to modify its existing automatic 18% tip practice in light of the new regulations. Under a new system, the chain will suggest tips amounts of 15%, 18% or 20% on all bills, whatever the size of the party (but leave the tip line blank). Diners have the choice of tipping more or less than these suggested percentages — or not tip at all.

"I don't want my tips to be on my paycheck as a wage," says a LongHorn Steakhouse server named Tamie Cordoba. "I like to get my tips at the end of my shift because I know what I'm getting right away." As noted in the WSJ article, Cordoba's base wages are $4.25 an hour, averaging $144.50 to $161.50 during a workweek of 34-38 hours. Cordoba, who says she usually sees $500 to $600 a week in tips, prefers being paid when her shift ends because, she says, "In this industry, that's what we live on. If I had to wait two weeks I don't know how I'd survive."