IRS Rule Leads Restaurants to Rethink Automatic Gratuities

Date: September 17, 2013

Ruling Will Treat Automatic Tips as Wages

In a little-discussed ruling issued in June 2012, the Internal Revenue Service announced that automatic gratuities (when a restaurant automatically adds a percentage to a bill for a large group) are service charges, rather than tips for tax purposes.
Revenue Ruling 2012-18 also announced that to the extent any portion of a “service charge” is distributed to an employee, it is wages for FICA tax purposes.
The IRS delayed enforcement of the ruling until January 1, 2014, so employers should now work to ensure that their automated or manual tip reporting systems comply with the agency’s interpretation.
What’s a tip? A tip satisfies the following four factors:
1.      The payment must be made free from compulsion.
2.      The customer must have the unrestricted right to determine the amount.
3.      The payment should not be the subject of negotiation or dictated by the employer policy.
4.      Generally, the customer has the right to determine who receives the payment.
What’s a service charge? A restaurant’s policy of adding an 18 percent service charge to the bill for parties of six or more is a service charge rather than a tip because the customer could not determine the amount of the payment.
What does this mean for restaurants?
  • Treating automatic gratuities as service charges will require restaurant owners to pay higher wages to those employees who receive the automatic gratuity. 
  • This adds to the paperwork burden faced by restaurant owners, who must change their payroll systems to comply with this change. 
  • Because of this increased burden, many restaurant owners may simply stop using automatic gratuities. 
  • This will hurt the bottom-line for employees as well, who will no longer have the security that they will not be stiffed on a tip when waiting on large parties. 
Updated September 18, 2013

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