In the past I have warned restaurant owners about the difference between a tip and a service charge. Collectively restaurant companies nationwide faced settlements well into the eight figure range for ignoring the difference between these who terms. The lingering issue to be determined was whether automatic gratuities were legally a tip or a service charge. A new ruling by the IRS went into effect on January 1st, 2013 and could represent a bigger financial burden on restaurants than the new health care law.
Before I get too deep into explaining the new law, let me first define a few terms.
Tip: An amount left by a guest for their server or bartender. This amount is determined by the guest.
Service Charge: A previously agreed upon amount charged by the restaurant for services provided. This is generally associated with large pre-planned events or banquets. The restaurant is allowed to retain a portion of this amount; however it cannot be considered a tip for the purposes of a tipped employee wage credit.
Automatic Gratuity: A fixed amount charged to large parties. This charge is usually stated on the menu and no explicit agreement to pay it must be reached in advance. The restaurant does not retain a portion of this amount.
In practice, here is how it works. If you have a cup of coffee, you pay a tip. If a large group from your office goes out for happy hour, the restaurant may tack on an automatic gratuity. If you plan your company’s holiday party for 100 people, you will likely sign a contract that includes a service charge. In all three cases you might consider it a tip. The IRS has made it clear that they disagree.
In June, 2012 the IRS issued a ruling that took effect on January 1st. They clarified that for tax and wage purposes that automatic gratuities are to be treated as service charges. The amount given to the servers should be considered wages and not tips. The full amount of the automatic gratuity should be considered revenue by the restaurant. This creates significant changes in that completely change the way servers and restaurants treat this money.
For restaurants, they must pay taxes on this income. They should also be charging sales tax on this amount since it is being paid to the restaurant. This also precludes them from applying the gratuity to the tipped employee wage credit. Most states allow employers to pay tipped employees less than the minimum wage by taking a credit for the amount of tips that employee receives. Effective Jan 1st, automatic gratuities cannot be applied to that credit. This means tipped employees working exclusively on tables who have an automatic gratuity added must be paid the full minimum wage.
This may seem like good news for servers, but it opens the door for some disastrous consequences. First, since the automatic gratuity is a wage it may be withheld until payday and be fully taxed. Second, since it is now considered a service charge, the restaurant may retain any or all of the automatic gratuity. Third, if the server is also waiting any tables not subject to the automatic gratuity, the previous two points apply and the server can still be paid at the lower hourly wage. (While the third point is technically true, I pity the restaurant that has to defend that technicality in a class action lawsuit.)
So the question becomes, “who benefits from this ruling?” The big winner is the IRS and local governments. They just became able to tax the automatic gratuity as revenue, wages, and sales. The next winner is the unscrupulous restaurant owner. They now have carte blanc to retain what the guest perceives as an employee’s tip and pay the server a flat hourly wage for as long as they can fight off lawsuits based on the technicality of the law.
The losers in this ruling are honest restaurant owners who choose to do the right thing and remit all of the automatic gratuities to their staff. Servers that work for unscrupulous owners will now see them legally stealing their income until they can win a court ruling and countless appeals. The biggest loser is the guest. Now they have no idea where their “tip” is going and will receive service that reflects no incentive to earn a larger tip that will only line the pockets of the restaurant owner.
No one should be happy about this new ruling. The IRS certainly is not in the business of trying to make people happy. It should at least strive for clarity and fairness. This clarification did nothing except create the potential for abuse. My advice to restaurant owners is to comply with the law for tax purposes, but keep your hands off of what the guest considers a tip. As many restaurant companies found out last year, the price tag of such abuse is generally handed out by a judge and is far more costly than simply obeying the intent of the law.