Tax Notes Newsletter

Tip Reporting
By Leo Parmegiani, Partner
Effective January 1, 2014, the IRS will begin enforcement of the proper treatment and reporting of tips versus service charges; in particular with respect to auto-gratuities i.e., charges that are compulsory to customers. If an item is considered a service charge, it is treated as wages for income and social security purposes and thus accounted for in a less advantaged manner for tax purposes. The initial effective date was January 1, 2013 but was extended one year by the IRS. What is a Tip vs. Service Charge? Tip is not defined in the Internal Revenue Code or Treasury Regulations and an employer's characterization of a payment as a tip is not determinative. However, Revenue Ruling 201218 provides criteria.

Leo Parmegiani Partner

lparmegiani@odpkf.com 212.286.2600

According to this ruling, the absence of any of the following creates a doubt as to whether payment should be characterized as a tip: 1. 2. 3. 4. Payment is made free of compulsion, Customer has unrestricted rights to determine the amount, Payment is not subject to negotiation or dictated by employer policy, or Customer has the right to determine who receives the payment.

If any payment does not meet all of these criteria, it is likely a service charge. Common Examples of Service Charges Large Party Charge (restaurant) Bottle Service Charge (restaurant and night club) Room Service Charge (hotel and resort) Contracted Luggage Assistance Charge (hotel and resort), and Mandated Delivery Charge (pizza or other retail deliveries)

The application of the factors is illustrated by the following two common examples: Example A: Restaurant W's menu specifies that an 18 percent charge will be added to all bills for parties of six or more customers. Customer D's bill for her party of eight includes an amount on the "tip line" equal to 18 percent of the price and the total includes this amount. Restaurant W distributes this amount to the waitresses. Under these circumstances, Customer D did not have the unrestricted right to determine the amount because it was dictated by employer policy. Customer D did not make the payment free from compulsion. The 18 percent charge is not a tip; it is a service charge dictated by Restaurant W. Example B: Restaurant X includes sample calculations of tip amounts beneath the signature line on its charge receipts. The actual tip line is left blank. Customer G's

charge receipt shows sample tip calculations of 15, 18 and 20 percent of the price of food and beverages. Customer G inserts the amount calculated at 15 percent on the tip line and adds this amount to the price to compute the total. Under these circumstances, Customer G was free to enter any amount on the tip line or leave it blank; thus, Customer G entered the 15 percent amount free from compulsion. Customer G and Restaurant X did not negotiate the amount nor did Restaurant X dictate the amount. Customer G generally determined who would get it. In such case, the amount Customer G entered on the tip line is a tip. If a payment is considered a service charge under the above definition, effective January 1, 2014, there will be a significant impact to the employer's accounting for payroll. For example, Automatic gratuities will no longer qualify as a tip for the favorable FICA tip tax credit Employers will have to treat automatic gratuities as wages for the purposes of immediate withholding of federal taxes, and employees will not receive their automatic gratuities until the employer's payday.

Because of this difficulty in implementing these rules and the loss of tax credit, many employers are opting to avoid automatic gratuities by placing suggested tip amounts on food and beverage charges to avoid the characterization as a service charge. If an employer chooses to maintain its automatic gratuity policy, accounting and policies must be in place to correctly account for these items as wages and not tips. Also, tax projections going forward should assume that the FICA tip credits will be drastically reduced as a result of the change in law. Many restaurants that continue to characterize the payment as tips have already modified their receipts to show suggested tips. For those that have not, time is of the essence. For more information, please contact Leo Parmegiani at lparmegiani@odpkf.com or 212.286.2600 or your OConnor Davies Tax Adviser.
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