It’s common for U.S. restaurants to automatically add a gratuity to the bill for large parties. But a new IRS rule, scheduled to take effect in January 2014, may make this practice a thing of the past. That’s because these built-in tips will increase the business’s tax-compliance costs and paperwork requirements.
The New IRS Rules on Tips and Taxes
The Internal Revenue Service will still treat tips as non-wage earnings, which means individual employees must report tips in excess of $20 per month to employers and which means employers can count these tips as a credit to reduce their minimum wage obligation (tips count towards paying an employee’s wages so an employer can pay less than the state and federal minimum).
As NPR reports, however, the IRS recently ruled that a “tip” must be “given without compulsion” and that the customer must “have an unrestricted right to determine the amount.” An automatic gratuity, which is usually set at 18 percent, isn’t voluntary and doesn’t give customers this discretion.
As a result, the IRS plans to treat these built-in fees as service charges and not tips starting in 2014. Service charges, of course, must be reported as regular wages. So, as the Wall Street Journal notes, employers will be required to include service charge payments in employees’ W-2 wages. This adds paperwork and compliance costs for restaurant owners, who must now track and report any automatic tips. Employers are also required to withhold income taxes on this service-charge income when paying employees.
What’s more, this also adds a direct cost, because you cannot use the money now defined as a “service charge” towards your tip credit and because you are responsible for paying a portion of the employee’s tax on this income (Employers pay 6.2 percent of workers’ Social Security taxes and 1.45 percent of employees’ Medicare taxes). Your tax burden is increased along with paperwork and compliance costs.
The IRS rule originally was scheduled to take effect in June 2012, but the IRS delayed its implementation until January 2014 to give restaurants time to comply. As NPR reports, major chains like Olive Garden, LongHorn Steakhouse, and Red Lobster have taken the opportunity to eliminate automatic tipping by large parties. Smaller restaurants may want to follow their lead to avoid increasing their tax burdens.
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