Restaurants Deal with New IRS Tip Rule

Date: March 17, 2014

Automatic gratuities are now classified as service charges, which are subject to payroll tax withholdings.

It’s common for restaurants to add automatic gratuities to large parties’ checks. But that practice could become history as restaurants deal with a pesky tax rule that took effect at the start of the new year.

On Jan. 1, the IRS began classifying automatic gratuities as service charges instead of tips. The agency treats service charges as regular wages subject to payroll tax withholdings, which means servers won’t receive automatic tip money until they receive their full paychecks.

The rule, which the agency implemented in order to crack down on unreported tip income, will complicate paperwork for restaurants that retain automatic gratuity policies. Accountants will need to factor automatic tips into hourly pay rates, which could vary depending on the number of large parties the restaurant serves. And restaurants that keep their policies will also lose income tax credits they used to receive for paying Medicare and Social Security taxes on employees’ reported tips, because service charges aren’t eligible for such credits.

“The easiest way to avoid these complications would be to not add gratuities to large groups,” says NFIB member Marcia Wagner, owner of The Grill House in Allegan, Mich.

At press time, Wagner planned to consult her accountant and payroll company to decide whether to drop automatic gratuities. But Wagner has another worry. “I am concerned about minimum wage for servers going up to levels that are being discussed,” she says. “To cover labor costs and maintain superior service, menu pricing would increase substantially.”

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