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How does the IRS determine the difference between a tip and service charges?

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John Dundon, II EA
According to IRS administrative guidelines to its examiners concerning Rev. Rul. 2012-18, published in the 2012-26 Internal Revenue Bulletin, when performing a tip examination (aka audit), IRS examiners must ensure that service fees or charges are properly characterized as wages and not tips. If the payment is not a tip then it is a service charge and reported as wages.
Whether payments should be reported as tips or service charges basically distills down to whether the following factors were present:

(1) The payment was made free from compulsion;
(2) The customer had the unrestricted right to determine amount;
(3) The payment was not be the subject of negotiation or dictated by employer policy; and
(4) The customer determined who receives the payment.

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