Note To Service Industry: IRS Says Service Charges Are Not Tips!

By September 9, 2013 Businesses, Individuals

The IRS has recently released an updated tax rule that differentiates between tips, which are voluntary payments to service personnel such as waiters, waitresses, bartenders, valet staff, etc. and service charges, such as those automatically applied to bills by restaurants for groups of certain sizes.

Beginning January 2014, the IRS will treat any automatic gratuity as a service charge, meaning that those amounts are not treated as tips to wait staff, but rather as full-fledged payroll.  This will change the way most restaurants handle payroll and tips to employees.  In the past, employees have been generally paid a specific hourly wage with tips (and service charges) paid separately as a total amount, often at the ends of shifts.  The change by the IRS will have numerous effects that restaurants, their employees, and consumers should understand.

First, restaurants are going to have to decide whether to keep mandatory service charges in place for large parties.  Historically, restaurants have included such service charges in order to avoid their wait staff being stiffed on large tabs.  Nevertheless, restaurants may have to make the trade-off between happy wait staffs and simpler payroll calculations.  A restaurant keeping the service charges in place will have to calculate not only the hours worked at their employees’ standard hourly rates and the tips to include on the W-2 as they have, but also the service charges attributable to each employee.

The additional step may seem simple enough, but let us look at a common example of how this quickly becomes complicated: Three servers share a large party in the same evening when two of the servers share another large party and the third server works two smaller tip-only tables alone.  Of the three servers, one goes home with some of his tips in his pocket, though he will have to wait for his paycheck to get all of them, and the other two waiters must wait for their paychecks entirely.  Is there an HR risk here?  Do employees start fighting management or each other with regard to table assignments to ensure they don”t get stuck serving tables with service charges so that they can go home with cash rather than having to wait for their paychecks?  How will restaurants maintain and calculate this information?  These will have to be calculated table-by-table, employee-by-employee, shift-by-shift in arrears to calculate payroll every two weeks (or however often payroll is computed).  By contrast, dropping service charges altogether allows restaurant management to maintain the relative simplicity of the old payroll-and-tips paradigm: calculate payroll checks as hours worked times the hourly rate, pay tips at the ends of shifts, and report the total on the W-2.  Done.

Second, employees will need to know how this affects their paychecks.  Employees used to receiving their tips via cash or check at the end of each shift may see a drop in the amount received, causing a potentially significant change in their budgeting habits.  This might be a bit of a boon for tax collections, though: Those employees who have received cash tips in the past out of the restaurant’s register may no longer be able to get away with excluding income from their tax returns either, as service charges will be included in standard payroll and reported automatically on their W-2s in Box 1: Wages, Tips, Other Compensation.

Finally, as consumers, it is important to be sensitive to the change that restaurant employees will be experiencing.  Restaurants that choose to drop service charges may see a drop in tip levels on large bills for large parties.  That means that their wait and bar staffs may essentially be getting a pay decrease.  It is important that consumers accurately calculate the appropriate tip, if only as a matter of etiquette.  On the other hand, this could eliminate slack performance by a waiter with a larger party, knowing that he is already receiving a guaranteed gratuity.

In an on the matter, the Wall Street Journal reported that, to combat the latter effect, many restaurants are beginning to suggest tip amounts to help customers accurately calculate tips.  For example, Darden Restaurants, Inc. (NYSE: DRI), the owner of Olive Garden, LongHorn Steakhouse, and Red Lobster is beginning to include suggested tip amounts at the 15%, 18%, and 20% levels at certain locations.  The hope is that customers will see these figures and take it upon themselves to tip appropriately.  If successful, the company will expand the practice to all locations.  It is likely that many other restaurants will follow suit.

The bottom line: those who eat at, own, or work for restaurants are about to be affected by this seemingly small, but far-reaching modification to the Tax Code.  There will be ongoing debates about what constitutes a “service charge” and when something crosses from being a “tip” to a “service charge.”  At present, the metric appears—“appears” being the operative term—to be simple: if it is voluntary, it is a tip; if not, it is a service charge.  We will go with that… for now.