New 2014 tip law may trip you up

Barran Liebman
Oregon Law Firm

IRS Offers Restaurants a Tip:”Mandatory Gratuities” Are Not Tips

Service charges need to be reported differently than tips under the IRS guidelines and a Revenue Ruling that went into effect on January 1, 2014. Therefore, it is important for service industry employers to properly classify service charges. But what are service charges, and how do they differ from tips?

Some restaurants, private clubs, and similar businesses impose a mandatory gratuity on larger parties (often eight or more patrons) that is automatically added to the final bill. (This is also a common practice for all diners at private clubs.) However, this mandatory charge is not a “tip;” rather, it is deemed a “service charge” and, as such, has different requirements than a tip voluntarily left for a waiter or waitress. Under federal regulations and IRS guidelines, tips are voluntarily given by customers as a gift or gratuity in recognition of a service performed by the server. Compulsory service charges added to bills are not voluntary (the patron does not have the unrestricted ability to determine whether to pay anything and, if so, how much); therefore, they are not tips, even if distributed to employees.

The distinction is important because the designation of mandatory gratuities as wages rather than tips will have employment tax repercussions. Tips are the property of the employees who receive them, and cannot be used by the employer for any purpose that is not statutorily permitted by the Fair Labor Standards Act. Conversely, service charges are gross receipts of the employer, and the employer is free to use them however it sees fit. When the employer chooses to distribute amounts collected from service charges to employees, these amounts are wages, not tips, and must be categorized and treated as such, including the withholding of proper taxes for the employee and payment of payroll taxes by the employer. Additionally, in states where tip credits are allowed (Oregon expressly forbids tip credits), distributed service charges do not count as tips for purposes of meeting that credit.

Employers utilizing service charges should take time now to review and revise their practices to be sure that amounts collected from service charges are being treated appropriately.

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