Member restaurants and accounting firms have been receiving notification from the IRS reinforcing their position after IRS Revenue Ruling 2012-18 issued June 2012 that IRS tax examiners must ensure that distributed service charges are properly characterized as wages and not tips.
U.S. Department of Labor (DOL) regulations, IRS interpretations, and Wisconsin law distinguish between a tip voluntarily paid by a customer and a mandatory service charge imposed upon the customer.
II. What Is a “Tip” and What Is a “Service Charge”?
A service charge is a gratuity automatically added to a customer's bill by management. A tip is a gratuity voluntarily added to the bill by the customer.
The IRS lists four factors, all of which must be present in order for the customer’s extra payment to be deemed a tip:
• The customer’s payment must be made free from compulsion;
• The customer must have the unrestricted right to determine the amount;
• The payment should not be the subject of negotiation or dictated by the employer policy; and
• Generally, the customer has the right to determine who receives the payment.
Similarly, under Wisconsin state law, Wis. Admin. CodeSec. 272.03(2)(c), the customer must have the sole discretion to determine whether a gratuity is to be given, to whom it is to be given, and the amount.
The IRS Rev. Rul. 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 buspersons. 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. The customer did not make the payment free from compulsion. The 18 percent gratuity is not a tip within the meaning of section 3121 of the federal tax code. 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 a tip within the meaning of section 3121 of the federal tax code.
IV. Effect if Gratuity Is a Service Charge
If the gratuity is deemed to be a service charge rather than a tip, under federal law, service charges:
• belong to the establishment
• become a part of the establishment's gross receipts
• must be considered as income to the employer, and
• 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 as a tip and used as tip credit. Thus automatically added or mandatory gratuities, e.g., for large parties or catered events, are service charges, not tips, and employers cannot take a tip credit, even if management passes the gratuity to employees. Instead, the mandatory-gratuity receipts would be considered part of the employer's receipts. Money paid from those receipts to employees would be considered wages rather than tips. The DOL maintains that a compulsory service charge is not a tip and cannot be counted as a tip even if the employer distributes the service charge to employees.
V. Customer Notice of Service Charges:
It is important for restaurants to inform guests of service charges and the amount of the charge before the guest orders, either by a conspicuous notice on the menu or some other means. It is also now important as a result of the U.S. DOL’s new tip credit notice regulations issued May 5, 2011 that employers notify tipped employees of specific information concerning tips and tip credit. Contact us or log onto http://www.wirestaurant.org/pdf/membership/Tip_Credit_Employee_Notification.pdf to see the tip credit information you must now provide.
Make sure your accountant or bookkeeper is aware of this issue. WRA will keep members informed as we learn more about how this is being enforced. You may also view this online by accessing the National Restaurant Association Legal Problem Solver.
Please call or email the WRA Hotline Team at 800-589-3211 if you have additional questions.