Tips vs Service Charges: The IRS Changes the Game

It happens everywhere to restaurant patrons in large parties (six or eight or more): the restaurant tacks on an automatic gratuity percentage so that math-compromised guests don’t shaft the server(s) at the end of the meal. Tipping also helps to keep menu prices stable and attract high quality servers. So even as the American economy crawls slowly into a healthier place, the IRS ruling that an automatic gratuity is really a service charge tosses the country’s wait staff a rotten tomato.

The difference between tips and service charges is significant because tips are not subject to FICA (Federal Income Contributions Act) withholding and service charges are. This new ruling classifies service charges as a wage rather than a free-will payment made by a patron at the end of a meal. Ultimately, it means that while the wait staff eventually get their portion of the service charge, it is deferred and added into their wages with FICA, state and federal withholding taxes deducted.

To qualify as a tip or gratuity, a customer’s payment to a server must meet four requirements:

  • The patron makes the server’s payment of his or her own free will
  • The patron decides the amount of the server’s payment
  • The patron decides which server(s) are given an additional payment
  • The payment made by the patron is not negotiated or set by the restaurant’s policy

Automatic gratuities, now considered service charges, flunk the tip test on all four factors. So the service charge becomes part of the server(s) wages paid every week or two weeks, not hard cash they take home that evening.

The new ruling also changes how restaurants, country clubs and other hospitality enterprises handle their automatic and manual reporting for IRS purposes. The ripple effect is potent as merchant services and hospitality management software and terminals now must be adjusted to accommodate the IRS ruling.

Some restaurants are changing their employment model to pay servers a living wage rather than providing a low hourly rate and expecting the rest of the server’s money to come from serious hustle and schmooze. Still other restaurants are avoiding the service charge issue by providing large parties with suggested gratuity tables of 15 percent, 18 percent and 20 percent of the total check, then letting the patrons make the ultimate decision on tipping themselves.

For more information about merchant services and hospitality management systems, please call Mike Krause here or at (585) 672-6381.

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