In Revenue Ruling 2012-18, the IRS recently provided a question and answer style of guidance to restaurant employers and employees in an effort to distinguish between tips and service charges. While the IRS’s guidance clarifies the difference between tips and service charges, it raises new challenges for restaurant employers that add an automatic gratuity or service charge for banquets or parties over a certain number.
In determining whether a payment is a tip, what an employer calls the payment, or whether an employer “pools” tips or “tips out” employees, is irrelevant. Rather, the determination is based on the facts and circumstances under which the payment was made. Specifically, the Ruling provides that the absence of any one of the following factors “creates a doubt” as to whether a payment a tip:
The payment must be made free from compulsion (voluntarily);
The customer must have the unrestricted right to determine the amount;
The payment should not be the subject of negotiation or be dictated by employer policy; and
Generally, the customer has the right to determine who receives the payment.
The Ruling provides two examples of how these factors apply. The first example describes a situation where a restaurant’s menu provides for the automatic application of an 18% gratuity charge for parties of six or more people. In this situation, guests do not make the payment voluntarily; nor do they have the unrestricted right to determine the amount of the payment. The payment in this example is considered a service charge, and will be considered wages when distributed to employees.
The second example describes a situation where a restaurant’s check contains sample calculations of tip amounts, but the actual tip line is left blank. In this circumstance, the amount was not negotiated or dictated by the employer, and guests are free to determine who and how much, if any, to pay. Accordingly, the payment in this example is considered a tip.
While these factors are easy to apply in a vacuum, it becomes much more difficult in the reality of restaurant operations. For example, over the course of the same shift, employees might serve several tables subject to an automatic gratuity, and several tables not subject to an automatic gratuity. In such case, keeping track of which payments are tips and which are service charges could be a logistical nightmare.
Whether a payment is considered a tip or a service charge can have a number of other effects on a restaurant’s business. For example, in many states, restaurants may apply a credit towards the minimum wage based on employees’ tip earnings. Now, employers must much more carefully determine whether a payment was a tip or a service charge when applying this credit. As such, if an employee works a banquet or other situation where a restaurant charges an automatic gratuity to guests, the employee must be paid the federal minimum wage for time worked.
The tip/service charge distinction also impact how employees’ overtime payments are calculated. Where a restaurant pays a portion of automatic gratuities to its employees, these payouts are considered wages, and will count toward employees’ regular pay rate when calculating overtime. Employers should keep in mind that this calculation might be further complicated by the fact that some jurisdictions, such as New York State, examine and define tips differently than the IRS.
Determining whether payments are tips or services charges is now a very fact specific task that can greatly impact a number of issues, including employees’ wages and overtime payments. Now is the time to begin considering how to adapt to these new regulations – such as, for instance, “suggesting” rather than requiring a particular gratuity amount. Although the Ruling is retroactive, in some limited circumstances given employers’ need to change their practices, the Ruling will be enforced prospectively to amounts paid beginning January 1, 2013. Employers are encouraged to confer with their tax advisors and attorneys to assist in navigating the consequences of this Ruling.