Effective January 1, 2014, the IRS began classifying automatic gratuities commonly added to bills of large parties in a restaurant as service charges instead of “tips.”  According the IRS Revenue Ruling 212-18, gratuities treated as service charges will be classified as regular employee wages and subject to Social Security and Medicare withholdings.  More importantly, restaurants that regularly use mandatory gratuities may lose their “tip credit” under the federal (and possibly, state) minimum wage laws, requiring such restaurants to pay regular minimum wages to their employees.

In its ruling, the IRS explained that an employer’s characterization of a customer payment as a “tip” is not determinative.  Instead, the IRS will consider the following four factors to determine whether a customer payment is a tip or service charge:

  • Payment is free from compulsion;
  • The customer has the unrestricted right to determine the amount;
  • Payment is not subject to negotiation or dictated by employer policy; and
  • The customer has the right to determine who receives the payment

The absence of any of the above factors creates a doubt whether a customer payment is a tip and not a service charge.  Thus, by definition, automatic gratuities that fail any of the above factors will be deemed as service charges.

Impact of the Ruling on Employers

Traditionally, restaurant employers have been able to take a tip credit for gratuities received by employees.  For example, in Illinois, the restaurants typically pay their employees the reduced minimum wage of $4.95 per hour, plus gratuities.  Under the new IRS ruling, however, the restaurant employers using mandatory gratuities are deprived of the tip credit.  For example, the restaurants’ employees would need to be paid the full minimum wage (in Illinois, $8.25 per hour) any time they are serving customers or large parties with automatic gratuities.

Typically, cash tips received by the restaurant’s servers are reported by the restaurant-employer, distributed to the servers on the same night, and then reported as additional “tip wages” subject to applicable FICA taxes.  Now, gratuities deemed as service charges under the new IRS ruling will have to be run through the restaurant’s payroll, have taxes withheld, and are then distributed to servers as a part of their regular payroll paycheck.

Similarly, restaurants using mandatory gratuities will have to factor service charges paid to the employees into their base compensation for purposes of determining employee’s overtime pay.

Strategies for Employers

There are a few ways for employers subject to this ruling to avoid reclassification of wages.  The most obvious way to avoid the impact of the ruling is to eliminate the mandatory gratuities.  This would place the risk and burden on employees to rely on the customers to tip at a similar level.  Whether that is 15 or 20 percent, it would be up to the customer to decide how to compensate the service of the restaurant.

Although this may seem to place too much control over employee compensation in the customer’s hands, it is one way for a restaurant employer to manage costs and avoid additional financial burden associated with the new ruling.

Another simple solution is to simply pay all employees the minimum wage and forget about the tip credit.  Yet, it may also increase the employers’ cost of doing business and deter some employees from providing quality and efficient services.


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