By Ken Berry
A little-noticed tax change could have a major tax impact on business clients who own and operate restaurants or other establishments that commonly add automatic gratuities to the bills of large parties. Beginning in 2014, these "tips" will be treated as "service charges", which will lead to numerous payroll tax complications.
In 2012, the IRS issued a new ruling clarifying past guidance, in which it narrowly defined the tax parameters for tips (Rev. Rul. 2012-18). Unless four critical factors exist, the IRS now says that a nondiscretionary charge to a customer is treated as wages for payroll tax purposes (see sidebar). But at least the IRS was persuaded to postpone implementation of the revised tax treatment for one year – until January 1, 2014. Initially, it was scheduled to take effect in 2013 (Announcement 2012-50).
The new rule applies to automatic gratuities that are frequently included for larger parties. For example, a restaurant may routinely charge an automatic tip of 18 percent for parties of ten or more people. The charge is usually stated on the restaurant menu. This policy ensures that servers won't "get stiffed" with a tip of a measly few dollars – or even worse, nothing at all – on a tab running into the hundreds. With many waiters and waitresses earning below the federal minimum wage of $7.25 an hour, tips are an important component of their take-home pay.
But the IRS has long-suspected that tips often aren't properly reported. An employer with a business where tipping is common, such as a restaurant, is generally required to report the amounts that workers receive in tips and to pay its fair share of payroll taxes on those amounts. Food and beverage establishments are eligible for a general business tax credit for a portion of those payments. Employees must report tips to employers and pay both income and payroll taxes on the tips they receive.
The change for automatic gratuities could create payroll snafus for certain employers. Because the payments will be treated as wages to employees, employers like restaurants and banquet halls will have to withhold income tax on those amounts. As a result, they'll be forced to factor the payments into the hourly pay rates of employees. Also, the rules might differ under state tax laws, further complicating pay rates. Finally, as opposed to tips, payroll taxes on service charges payments aren't eligible for the general business tax credit.
For their part, employees aren't likely to be thrilled, either. Due to the change, they'll have to wait unto they receive their regular paychecks from the employer instead of pocketing large tips on the day of the service.
If this tax change is allowed to stand, you might advise your business clients in these industries to give customers more leeway in adjusting the amount of such charges or to even forego automatic gratuities entirely. The extra hassles might not be worth the benefits.