An updated tax rule is causing restaurants to rethink the practice of adding automatic tips to the tabs of large parties. These automatic tips are usually 15% to 20%.
Starting in January 1st, 2014, the Internal Revenue Service (IRS) will begin classifying those automatic gratuities as service charges, which are treated as regular wages, and are subject to payroll tax withholding. Unlike tips, which restaurants leave up to the employees to report as income.
The change would mean more paperwork and added costs for the restaurants, and a possible financial hit for waiters and waitresses who live on their tips but don’t always fully report them on their tax returns.
Many restaurants across the nation include an automatic 15% to 20% gratuity for parties of 8 or more. Because this gratuity is added in by the restaurants, and, diners don’t have a choice as to the amount of tip to pay, these will now be classified as “service charges”.
For restaurants that will keep this practice after January 1st, 2014, this will complicate their payroll accounting. They will then need to add those tips into their employee’s hourly rates and pay them as taxable wages.
So, not only will the employee get fully taxed on these service charges, but they will not see this money until pay day. That’s right, not until pay day. Because these will now be classified as service charges, and be calculated as regular wages, the employee will have to wait until pay day to get these fully taxable monies instead of getting them at the end of their shift. Many waitresses/waiters rely on their daily tips to get through their week, to pay for gas in their car or for a utility.
Restaurants are required to report to the IRS what its employee’s report they received for tips and to pay Medicare and Social Security taxes on those amounts. Restaurants are eligible for an income-tax credit for some or all of those payments, but service charges aren’t eligible for this tax credit.
The IRS ruling was issued in 2012 to clarify and update earlier tax guidance on tips, which didn’t clearly state how automatic tips were to be treated. Restaurants persuaded the IRS to delay implementation until 2014.
The IRS stated it noticed an increase in the use of “auto-gratuities” and that it believed “additional clarification in this area would be in the best interest of tax administration.”
The updated rule says the automatic tips are service charges because they aren’t voluntary. In a question-and-answer section of the ruling, the IRS provided an example of a restaurant suggesting different tip amounts, and said that practice isn’t subject to federal withholdings because the customer is still free to choose whether and how much to tip.
Still, the ruling has caused some confusion. Some restaurants insert an amount on the tip line and then remind guests on the check that they are free to adjust that amount up or down. Some feel that this “suggested amount” could come under scrutiny by the IRS if they decide it too looks like a service charge.
