Automatic Gratuity vs. Service Charge

This article is from FSR Magazine Finance Writer Kevin Hardy.  It was printed in January 2015 and provides an excellent overview of changes in the IRS requirements on the way automatic gratuities and service charges must now be approached. For more specific information on how these requirements impact your business, it is important to consult with your accountant. 

IRS Changes Rules on How Restaurants Tax Tips

The days of servers banking on large groups as a sure thing for a tip are gone—or at least will be soon.

In 2012, the IRS redefined how restaurants must classify automatic gratuities, often charged on parties of six, eight, or larger. But implementation of the change was delayed, with full enforcement beginning Jan. 1, 2014. No longer can restaurants and banquet halls count these automatic charges as tips—rather, they must be accounted as earned income.

While enforcement has been in effect for a year, experts say restaurants that have resisted the change should not hold out any longer in 2015, as the IRS moves toward cracking down on stragglers.

The IRS is giving restaurants a choice: They can ditch the automatic gratuity and make the charges optional tips, or they can charge an automatic service charge, which would be subject to sales tax and payroll tax withholding and would require restaurants to pay servers the full minimum wage.

Restaurants may suggest tips on large parties, but the IRS says those payments “must be made free from compulsion” by customers in order to count as a tip and not as regular wages. That means tips can’t automatically be added to a large group’s check. IRS Ruling 2012-18 also states customers must maintain the unrestricted right to determine the tip amount. The payment should not be the subject of negotiation or dictated by employer policy, and the customer generally has the right to determine who receives the payment.

Anil Melwani, a certified public accountant and managing partner of New York City’s 212 Tax & Accounting Services, says the change is causing administrative and bookkeeping stress for restaurants and nightclubs that count on business from large groups.

“But it’s a much bigger hit to the employees,” he says. “These automatic gratuities were usually adding 18, 20, or 22 percent. Now you’re leaving it up to the client; that means servers are making less in tips, which is a majority of what they make. It definitely hits the employees.”

It’s unclear when the IRS will ramp up enforcement, Melwani says. He hasn’t seen the IRS bust any restaurants for failing to make the change. But he’s advising his restaurant and nightclub clients to take the regulation seriously. The change comes at a time when the IRS and the U.S. Department of Labor were already targeting the foodservice industry for wage and labor infringement.

“It’s been around for enough time where you can’t really say, ‘I didn’t know about it,’” he says. “It’s definitely the time [to put it into practice].”

Restaurants Report Similar Tips Regardless of Gratuity Policy

Aside from deciding how to adjust to the change on automatic gratuities, Melwani says it’s important that restaurants maintain accurate records of employees’ tips and withhold the appropriate amount for income taxes, Medicare, and Social Security, as the IRS continues a wider crackdown on under-reported tip income. As for the new ruling, he says it’s just easier for most restaurants and nightclubs to cease automatic gratuities.

“As with most things the IRS does, they don’t always tell you why,” Melwani says. “They may have feared that it wasn’t all being distributed to the employees.”

It’s no surprise that servers don’t like the change. Their guaranteed tips of 18 or 20 percent vanish under the new IRS requirements.

“We got a little bit of pushback from the servers,” says Gary Sander, vice president of operations at Oklahoma City’s A Good Egg Dining Group, which in early 2014 ended automatic gratuities for groups of eight or larger. The restaurant group considered switching its automatic gratuities on parties of eight or more to service charges, but was dissuaded.

“We could have gone ahead and done that, but you have to keep so many records and have separate bookkeeping,” Sander says. “We could have done it, but it would have been a nightmare.”

The company promised to compensate servers if removing automatic gratuities resulted in a huge hit to their take-home pay. A Good Egg Dining Group operates a catering business and eight restaurants in the Oklahoma City area, six of which are full-service, white-tablecloth operations. At two of A Good Egg’s restaurants that host a large number of groups, Sander says managers tracked tips at the tables that would have previously been subjected to an 18 percent automatic gratuity. The results were surprising.

“We kept track of that for three months to see how it was actually affecting the servers, and we found overall, they ended up making more without the automatic gratuity,” Sander says. “But, on a case-by-case basis, there were certain nights where they got screwed. And those were the ones they remembered. So that’s why we monitored it. It wasn’t like, ‘Oh, I wish we’d been doing this all along.’ But it was overall better.”

Sander believes one or two servers might have left because of the loss of the automatic gratuity. But that’s not bad for a group that employs 400 people. Now that tips are completely optional for all tables, regardless of how large the party, the change is all but forgotten.

“It’s just become another ticket that has a gratuity added to it,” Sander says. “It’s just like any other table, really. We haven’t heard anything from the guests.”

Sander says it is the same story for many other restaurants in the area that have also nixed the automatic gratuities. “It’s going to come back and bite you one of these days if you aren’t doing it the way you’re supposed to,” he says. “So we do.”

IRS Cracks Down on Untaxed Tips

The IRS has billed its ruling as more of a clarification. But it has real operational implications for restaurateurs, says Joseph Henchman, vice president of legal projects for the Tax Foundation, an independent tax policy think tank. He says the IRS’ most recent guidance is just another in a series of actions designed to capture tip income.

“What the IRS is concerned about is the collection of taxes on tips and service charges. Historically, tip income was generally not reported to the IRS. Waiters would get them and a lot of it was cash, so it just didn’t cycle through the tax withholding and IRS system,” Henchman says. “The shift of payments from cash to credit has narrowed how much can escape attention. So they view the next logical step as cracking down on large parties.”

Servers at those restaurants that choose to keep automatic gratuities—now classified as service charges—won’t get the usual instant gratification that comes with regular tips.

“The difference is that tips can be cashed out day by day as they’re received; service charges go through the system,” Henchman says. “That’s a real shift in how servers receive their income. A lot of them are used to cashing out each night and now they have to wait for it to go through the payroll system.”

Aside from leaving many restaurant operators confused, Henchman says, the IRS rule change hasn’t been sensitive to the inherent operations and labor conditions of the industry. “The IRS’ broader objective should be to make sure people are paying taxes on their income. And if that’s being met, the agency shouldn’t need to micromanage how restaurants work.”