On June 25, 2012, the IRS issued Revenue Ruling 2012-18 which requires restaurants and other similar employers to treat “tips” differently from automatic “service charges” for tax purposes. The effective date for this change has now been extended to January 1, 2014.
Revenue Ruling 2012-18 clarified and updated the IRS rules on the tax treatment of tips in an effort to help employers distinguish between tips and service charges for purposes of, among other things, Federal Insurance Contributions Act (“FICA”) tax withholding obligations and reporting tip income. A payment must meet four requirements to be considered a tip: (1) the payment must be made “free of 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. Two common examples were provided in the Revenue Ruling to help tax payers differentiate between service charges and tips. First, if a restaurant includes an automatic service charge in the final bill given to the customer, such as those often added to bills for large parties, then this will not be considered a tip as this payment would not satisfy the four requirements discussed above. On the other hand, if a restaurant instead merely includes “sample tip calculations” on its charge receipt, but does not include any such amount automatically in the bill total, then the amount entered by the customer on the blank tip line will be considered a tip even if the customer does choose to leave an amount equal to one of the sample tip amounts.
For employers, this change means that company processes and business practices must be modified to now treat service charges that are distributed to employees as income to the restaurant and as non-tip wages subject to normal reporting and withholding rules. This change also means that service charge amounts must be counted for minimum wage calculations, overtime calculations and benefits contributions. Additionally, service charges will not apply with respect to the FICA tax credit as they are no longer considered tips.
For employees of businesses that continue using service charges, this means that service charge amounts passed on to the employee will now be subject to upfront withholding and will not be received by the employee until pay day. However, there is a belief that this Revenue Ruling will spell the end of many employers’ use of service charges.