Many restaurants have a policy of adding an automatic gratuity to bills of large parties and banquets, whether it is 15 percent, 18 percent, or 20 percent. Such a policy ensures that restaurant employees are adequately compensated for their work, as many guests find it more difficult to leave a 20 percent tip on a large bill than a 20 percent tip on a small bill. With an IRS ruling effective January 1, 2014, however, restaurants may want to reconsider the use of automatic gratuities.
Revenue Ruling 2012-18 classifies automatic gratuities as service charges, which are considered restaurant income. If these service charges are distributed to employees, they are considered wages and not tips. This disrupts the long-standing restaurant industry practice of treating automatic gratuities as tips.
In its ruling, the IRS clarified that an employer’s characterization of a payment as a “tip” is not determinative. Rather, four factors are considered to determine whether a payment is a tip or service charge:
The payment must be made free from compulsion;
The customer must have the unrestricted right to determine the amount;
The payment should not be the subject of negotiation or dictated by employer policy; and
Generally, the customer has the right to determine who receives the payment.
The IRS concluded that the absence of any of the four factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge. Thus, automatic gratuities—which fail to meet the criteria above—are service charges.
Service charges belong to the restaurant and are considered part of its gross receipts. Additionally, service charges are considered as income to the restaurant. Service charges may be retained exclusively by management or distributed to employees in any amount.
Why It Matters
Inability to take the “tip credit” in some situations. Perhaps the biggest hiccup with the IRS’s ruling is that restaurants can no longer take the “tip credit”—permitted by the Fair Labor Standards Act (FLSA) for employees who customarily and regularly receive tips—for employees who serve guests subject to an automatic gratuity. In other words, restaurants cannot count automatic gratuities toward the FLSA tip credit, even if they distribute the gratuities to employees. This poses an issue to restaurants because they must pay employees who serve these large parties and banquets at least the applicable minimum wage, as the employees are technically performing non-tipped work. This includes bussers and other front-of-the-house employees who are lawfully involved in tip pools.
Difficulty in determining wages for employees who have dual duties. Moreover, where employees have dual duties—e.g., they are simultaneously serving regularly sized parties (not subject to a service charge) and large parties or banquets (subject to a service charge)—restaurants face the daunting task of determining what wages to pay employees, as the employees are performing tipped and non-tipped work. The FLSA tip credit can be taken for only tipped work, but it is seemingly impossible to separate tipped work from non-tipped work when the tasks are performed concurrently.
Recalculation of overtime rates. A related issue is that restaurants need to recalculate employees’ overtime rates in situations where employees are paid a portion of automatic gratuities and they work more than 40 hours in a week or 8 hours in a day (depending on the state). Because the IRS’s ruling classifies automatic gratuities as wages and not tips, these payments count toward employees’ regular rates of pay, and consequently they must be factored into employees’ overtime rates.
Payroll and tax implications. The IRS’s ruling presents numerous tax implications. First, the Federal Insurance Contributions Act (FICA) tip credit permitted toward a portion of restaurants’ Social Security and Medicare taxes no longer applies with respect to service charges. Thus, the IRS’s ruling lowers the amount of the FICA tip credit available to restaurants.
Second, restaurants should report service charges distributed to their employees as wages—not as tips—on their payroll reports. Likewise, restaurants should omit service charges distributed to employees (assuming they exceed 10 percent of the sale) and respective sales when completing Form 8027 (Employer’s Annual Information Return of Tip Income and Allocated Tips).
Third, for income tax purposes, an event’s gross receipts will include the service charge as income, and the portion of the service charge distributed to employees should be reported as wages on the business tax return.
Eliminate automatic gratuities, but provide suggested tip amounts. The best method to potentially avoid the effect of the IRS’s ruling is to eliminate automatic gratuities. By permitting large parties and banquets to leave tips subject to their discretion, restaurants can avoid paying higher hourly wages, and the payroll and tax implications discussed above.
Discontinuing the use of automatic gratuities, however, may come with a cost. Restaurants would have to deal with guests who opt not to leave tips in accord with custom and practice. Undoubtedly, some guests find it more difficult to leave a $200 tip on a $1,000 bill than a $20 tip on a $100 bill, let alone a $2,000 tip on a $10,000 bill.
One alternative strategy to minimize this risk, is to provide suggested tip amounts. Restaurants do not run afoul of the IRS’s ruling by listing suggested tip amounts beneath the signature line on their bills, so long as the actual tip lines are left blank and guests’ tips are voluntary. In doing so, restaurants inconspicuously remind their guests that tips in accord with custom and practice are necessary to adequately compensate restaurant employees. Guests have the choice of tipping the same, more, or less than the suggested tip amounts; indeed, they may choose to leave no tip at all. Furthermore, this method is not the subject of negotiation between guests and restaurants, and guests generally have the right to determine who receives the payment.
An additional strategy to ensure that a restaurant receives tip amounts similar in size to automatic gratuity amounts is to list the desired tip amount as the lowest or second-to-lowest suggested tip amount. For example, if a restaurant previously had a 20 percent automatic gratuity, it may want to consider providing suggested tip amounts for 18 percent, 20 percent, and 22 percent of the bill. A guest may feel more comfortable leaving a 20 percent tip in this situation than if the suggested tip amounts provided are 15 percent, 18 percent, and 20 percent.
Continue using automatic gratuities, but pay employees above the applicable minimum wage.
Recognizing that many employees serving large parties and banquets often earned more than the minimum wage when automatic gratuities were distributed as tips, restaurants may want to incentivize employees by paying above the minimum wage.
It is important to note that restaurants should be cautious and mindful of employees performing dual duties. When employees are simultaneously serving parties subject to an automatic gratuity and parties not subject to an automatic gratuity, they are performing tipped and non-tipped work. Because the tip credit can be taken only for employees performing tipped work, this poses a problem for restaurants attempting to determine these employees’ hourly wage. The best solution is for restaurants to micromanage employees’ schedules to prevent them from simultaneously serving parties subject to an automatic gratuity and parties not subject to an automatic gratuity.
Brian Roth is an attorney in Gordon & Rees’s Chicago office, where he represents employers in lawsuits alleging discrimination, harassment, retaliation, and wrongful termination. He also represents employers in wage and hour collective action litigation in the Chicago office’s Wage and Hour Practice Group, which is led by partner James B. Hiller. Brian may be reached at email@example.com or (312) 980-6767.