For many restaurants and hotels, it was not the “Fiscal Cliff” or the Mayan Apocalypse that made them nervous this year but rather the January 1, 2013 deadline for compliance with IRS Revenue Ruling 2012-18. That announcement, issued on June 25, 2012, requires all restaurants to treat “tips” differently from “service charges” for tax withholding purposes and to make all required withholdings from “service charges” in the manner promulgated by the IRS. In some cases, this requirement was ordered to be immediate and retroactive. In many cases, however, the requirement was ordered to apply on a going forward basis, starting on January 1, 2013.
But, like the Mayan Apocalypse, disaster was delayed. In this case, the IRS announced on December 13, 2012, that Revenue Ruling 2012-18 will not be applied until January 1, 2014. The IRS provided this added year to allow business to develop systems to comply with its new rules.
What do these IRS announcements mean and what should business do with the extra time? The following provides a brief orientation.
The IRS released new guidance this year to help businesses distinguish between tips and service charges when reporting restaurant income. The tax treatment of each item differs. Tips are income to the server. Service charges are income to the restaurant. Service charges distributed to employees are characterized as wages for FICA tax purposes while tips, as income solely to the servers, are not subject to direct withholding by the employer.
Specifically, Revenue Ruling 2012-18, issued on June 25, 2012, updated the IRS rules of how FICA tax on tips and other wages may be applied. Revenue Ruling 2012-18 provides a series of questions and answers to help employers distinguish between tips and service charges for purposes of, among other things, administering their FICA tax withholding obligations and reporting tip income. In addition to Revenue Ruling 2012-18, the IRS issued an announcement which sets forth additional guidance on the treatment of automatic and manual gratuity systems.
Under these rules, a payment must meet four requirements to be considered a tip:
- The payment must be made “free from compulsion”
- The customer must have the unrestricted right to determine the amount
- The payment should not be the subject of negotiation or dictated by employer policy
- Generally, the customer has the right to determine who receives the payment
The IRS will doubt that any payment is truly a tip if any of the above circumstances do not exist surrounding the payment at issue. That said, all of the surrounding circumstances must be considered.
Rev. Rul. 2012-18 contains examples to help illustrate the concept. Here’s one: A restaurant policy of automatically adding an 18% charge to the bill of parties of six or more will constitute a “service charge.” By contrast, where a bill shows sample calculations of different tip amounts (e.g., 15%, 18%, or 20%), and the actual tip line is left blank by the restaurant, and in response to such bill the customer independently writes any amount on the tip line, then the amount the customer wrote will constitute a tip. Generally, therefore, “autograts” (i.e. service charges that are automatically added to a customer’s bill by the restaurant) shall be construed as a service charge rather than a tip.
Remember, service charges (including autograts) are income to the restaurant and must be recorded as such. The payment to the wait staff from such service charges must therefore be treated as payroll subject to regular withholdings, not as a tip.
What’s the difference? Employers are required to collect income tax, employee social security tax and Medicare taxes on all wages, including the tips reported by employees. But employers do not control their employees’ tips and therefore cannot withhold directly from them. Rather, employers withhold from the hourly wages they pay to their employees to cover the social security, Medicare and other tax liabilities of their employees on both the collected tips and the earned hourly wages. In order for that withholding to happen properly, employees must report their tips to their employer on Form 4070 by the 10th day of the month after the month in which the tips are received. While tip income is subject to FICA taxes and FICA withholding if there are sufficient regular wages from which the employer may make such withholdings, the employer is not secondarily liable for any shortfall and must simply report amounts under-withheld.
In contrast, collected service charges that are distributed by the employer to employees are treated as normal payroll wages subject to the normal reporting and direct withholding rules. This is because the service charge when collected from the customer belongs to the employer and is controlled by the employer, and these circumstances allow the employer to make all the normal withholdings directly from the collected service charge prior to making payment to the employee. Employers shall therefore be secondarily liable for any failure to withhold.
That means also that service charges paid to servers cannot be included in the calculation of the FICA Tax Credit. Service charges may also affect eligibility of servers for participation in the Tip Pool as well as the ability of the restaurant to use the Tip Credit as a way to lower the hourly wage to wait staff. It also means that wages characterized as service charges must be counted for minimum wage calculations, overtime calculations, benefits contributions, and determining whether regular wages are sufficient for withholding payroll taxes on tips. There are many implications associated with the differing treatment between tips and service charges. Companies should contact their accountant and/or tax counsel for specific guidance in this area.
With the additional time allowed by the IRS employers should consider the following in earnest:
· Audit the company’s processes and make any changes necessary to automated or manual reporting systems (including point of sale systems) and business practices (including tip sharing practices) so that such systems and practices may properly distinguish between service charges (which are directly subject to payroll withholdings) and tips (which are not controlled directly by the employer);
· Audit records to confirm that service charges have been treated properly as payroll wages rather than as tip income or, if service charges have not been so properly treated, whether any adjustments to the Form 941 may be appropriate.
· Contact the company’s accountant and/or tax counsel for specific guidance in this area.