Friday, January 3, 2014

Revised IRS Ruling Classifies Automatic Gratuities as Service Charges Subject to Payroll Tax Withholding

For years, it has been common practice in the hospitality industry to include an automatic gratuity on the bills of larger parties, usually defined as eight or more guests.  The purpose of this practice was to, among other things, ensure that servers were not short-changed on large tabs.  Prior to January 2014, automatic gratuities were treated as tips for employees to report as income.

Starting now, the IRS will classify automatic gratuities as "service charges," which means they will be treated as regular wages subject to payroll tax withholding (FICA).  

Hospitality employers should be mindful that their characterization of a "tip," whether communicated orally or in writing to employees, is not controlling for purposes of this rule.  According to the IRS, the absence of any of the following factors creates a doubt as to the status of a payment as a tip, and indicates the payment may be a service charge:

1.  the payment must be made free from compulsion; 
2.  the customer must have the unrestricted right to determine the amount; 
3.  the payment should not be the subject of negotiation or dictated by employer policy; and
4.  generally, the customer has the right to determine who receives the payment.

As a result of the revised IRS Revenue Rule 2012-18, located at, employers will not receive an income tax credit for the service charges, and employees will have to wait until payday to receive service charge money due to the federal tax withholding requirement.