When Is a Tip not a Tip?

John Stancil

When is a tip not a tip? According to the IRS, “when it is a service charge.” Under rules effective January 1, 2014, the IRS has redefined the terms “tip” and “service charge” for tax purposes. Under these rules, restaurants that charge an automatic percent charge for large parties may no longer treat these amounts as tips. Recent guidance has been issued to help restaurants more clearly understand their obligations and reporting requirements in this regard. This additional guidance could be an indication from the IRS of increased enforcement in this area.

In order to be classified as a tip, four criteria must be met:

1.The payment must be voluntary and not required by the restaurant. This does not preclude the restaurant from placing a “suggested” amount for a tip in the check. Or calculating a tip at certain percentages.

2.The customer has an “unrestrained” right to determine the amount.

3.The amount may not be the subject of negotiation or dictated by the employer.

4.The customer has the right to determine who receives the payment, although the server is not restricted from sharing with other employees. In other words, the tip is normally intended for the server, but the server is free to distribute it to other employees.

Additionally, it should be noted that tips do not have to be in cash but can be tickets, gift cards or similar items. Amounts received through tip pools or tip sharing are counted as tips.

Under these criteria, then, an 18 percent charge added to the bill for parties of six or more is not a tip. If the menu states that an automatic gratuity will be added to the bill, it is a service charge. Gratuities for catering, banquets, weddings and the like are included in these rules. Also included in the ruling are hotel room service fees, cruise-trip package fees, and bottle service charges in nightclubs and restaurant.

Since some employers retain a portion of the service charges or “automatic gratuities,” they are revenue to be reported by the business. Dollars distributed to employees are non-tip wages.

There are at least four implications for tax and payroll reporting as a result of these changes.

First, since service charges are considered wages, they are not eligible for the FICA Sec 45B tip credit, claimed on Forms 4666 and 3800). This is a credit the employer receives for the social security and Medicare taxes paid on your employees’ tip income.

Second, tips and wages are reported on separate lines of Form 941 and should be characterized correctly. This may require an adjustment to prior Form 941’s submitted.

Third, the Employer’s Annual Information Return of Tip Income and Allocated Tips (Form 8027) should not include tip income. This is a separate form, not to be included with the businesses’ regular income tax return.

Fourth, since payouts of service charges are considered wages, the employer may need to recalculate overtime rates for employees, as this affects their regular rate of pay. For example, an employee earning a regular rate of $8 an hour would normally be paid $12 an hour for overtime. If that employee receives service charges equaling $2 an hour, their pay rate is considered $10 an hour and should be paid $15 for overtime.

Implied in these changes is an adjustment in the reporting systems utilized by the restaurant to properly classify employee compensation, as the service charges must be captured and tracked separately from the tips.

Restaurants can avoid the complications associated with these rules by simply omitting the mandatory tip (aka service charge). This seems to be a good solution for mandatory “large party” tips, but may not be appropriate in a banquet, catering, or cruise-ship environment.

Restaurants and other companies whose employees receive tip or service charges should be vigilant about compliance with this legislation. Indications are that the IRS is going to take an aggressive stance against violators. The IRS has long been concerned about the lack of reporting of tips by servers and this seems to be a step toward more rigid enforcement. With the vast differences in restaurants from local breakfast eatery to a five-star restaurant, it would seem that one size does not fit all. A customized IRS approach seems to be in order.

Dr. John Stancil (My Bald CPA) is Professor Emeritus of Accounting and Tax at Florida Southern College in Lakeland, FL. He is a CPA, CMA, and CFM and passed all exams on the first attempt. He holds a DBA from the University of Memphis and the MBA from the University of Georgia. He has maintained a CPA practice since 1979 with an emphasis in taxation. His areas of expertise include church and clergy tax issues and the foreign earned income credit. He prepares all types of returns, individual and business.

Dr. Stancil has written for the Polk County Business Journal and has presented a number of papers at academic conferences. He wrote the Instructor’s Manual for the 13th edition of Horngren’s Cost Accounting. He is published in the Global Sustainability as a Business Imperative, Green Issues and Debates, The Encyclopedia of Business in Today’s World, The Palmetto Business Review, The CPA Journal, and in the NATP TaxPro Journal. His paper, “Building Sustainability into the Tax Code” was recognized as the outstanding accounting paper at the annual meeting of the South East InfORMS. He wrote a book entitled “Tax Issues Faced by U. S. Missionary Personnel Abroad ” that will soon be published.

He has recently launched a new endeavor, Church Tax Solutions, which presents online, on demand seminars on various church and clergy tax issues.

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1 comment on “When Is a Tip not a Tip?”

  • Patrick Kissane

    I can see no good reason for distinguishing between wages, service charges and tips. All other tax jurisdictions that I am acquainted with do not make this distinction.

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