The IRS has created a rule that will affect restaurants that charge automatic gratuities to their customers. IRS Revenue Ruling 2012-18 has classified all automatic gratuities placed on the customer’s tab as restaurant income and will therefore be considered wages, not tips. Four factors determine whether a payment is considered a service charge or a tip:
1) the payment is made free from compulsion,
2) the customer has the unrestricted right to determine the amount,
3) the payment is not the subject of negotiation or dictated by employer policy; and
4) the customer has the right to determine who receives the payment.
All charges that do not include one or more of the above-mentioned criteria will be classified as service charges and not a tip. Likewise, service charges will be considered as income to the restaurant and therefore part of its gross receipts.
Another aspect for restaurants to consider when deciding whether or not to use an automatic gratuity is the impact on the “tip credit” permitted by the Fair Labor Standards Act (FLSA). Restaurants will not be able to count their gratuities towards the FLSA tip credit if they continue to utilize automatic gratuities and therefore must pay their employees the applicable minimum wage.
Employees who engage in both tipped and non-tipped work, such as serving both large parties and banquets, will pose difficult questions for restaurant owners. The FLSA tip credit must only be used with tipped work so employers must distinguish between tipped work and not tipped work.
Restaurants who continue to use automatic gratuities must also factor in overtime implications. Restaurants must pay their employees a higher overtime rate because the service charges will be considered as wages and not tips.
Service charges will also have payroll and tax implications. The FICA tax credit permitted towards Social Security and Medicare will be lowered with respect to service charges. Additionally, service charges should be reported as salaries and wages on business tax returns for income tax purposes.
Obviously, automatic gratuities present problems for restaurants. But, there are certain solutions to avoid automatic gratuities that achieve the desired result. Restaurants can utilize suggested tips on their receipts instead of automatic tips. Suggested tips will give customers the discretion to choose how much of a tip to leave, but give restaurants the power to remind the customers that their tips are still appreciated. Restaurants may tell their guests that many of the restaurant’s employees are depending on tips. A server should be rewarded for a job well done. Additionally, restaurants should also do away with the jobs that include both tipped and non-tipped work as these jobs create unnecessary hardships under the new IRS Ruling.