By: Kristen D’Andrea June 4, 2014
A recent clarification to the Internal Revenue Service’s tip reporting rules has been a headache for restaurant owners and a disappointment for wait staff.
Effective Jan. 1, 2014, employers are required to differentiate between service charges, or payments that are automatically charged to a bill, and tips. Any gratuities automatically added to a customer’s bill, such as an 18 percent service charge applied to the bill of large parties, must be treated as wages, as opposed to tips, and reported on a W-2 so all applicable taxes are withheld. If a customer leaves a cash tip in addition to the automatic service charge, however, that is treated as a tip.
For employers, this means more bookkeeping and more expense. A service charge, characterized as Social Security wages rather than Social Security tips, is not eligible for a tip reporting credit, according to Dave McKelvey, partner in charge of the Long Island tax practice at Friedman in Uniondale. While employers can claim a Social Security credit for FICA obligations attributable to tips exceeding the minimum wage, taxes paid on service charges cannot be claimed for a credit.
Wait staff are feeling the negative effects of this change, as well. In addition to the gratuities now being subject to withholdings and going through the normal payroll process, the funds are generally delayed in getting to the waiters and waitresses, most of whom rely on daily tips as income, McKelvey said.
In the case of service charges, the mandate removes the employee from the situation and puts more of the burden on employers, according to Saul Brenner, a partner at Berdon in Jericho. Conversely, tips must be reported by restaurant employees to their employer by the 10th of the following month, said Sal Armao, managing partner and founder of Armao in Garden City. Restaurant owners are then responsible for withholding federal and state income tax, as well as FICA tax, from their employees’ wages.
Tip reporting can put restaurant owners in a difficult situation, said Michael Bohlsen, owner of Bohlsen Restaurant Group, which operates seven dining establishments on Long Island.
“We are responsible for the amount of tips reported yet we are not allowed to tell our employees what to report,” Bohlsen said, adding discrepancy among tips reported is not a regular issue at his restaurants, however. “We have a lot of long-term employees who have a vested interest to have continuation of employment,” he said.
Additionally, gratuities are always optional at Bohlsen restaurants, even for large parties, so his wait staff has not felt the effects of the IRS’ recent amendment.
To a large degree, employers rely on the honesty of their wait staff to maintain accurate tip records.
“It’s not a long shot to think there might be some poor estimation along the way,” Brenner said. Requiring the automatic service charge to be reported as wages is one way the IRS can ensure it’s capturing income due, he said.
However, a “tip,” an acronym for “to insure promptness,” is intended to ensure customers are served quickly, Brenner said.
“If it’s mandatory, it’s not considered a tip,” Brenner said, of the IRS’ decision to change its clarification.
Several national chain restaurants that have historically added a fixed gratuity for tables of eight or more are moving away from the practice since the IRS’ revision, McKelvey said.
“I think by the end of this year most places will not have an automatic service charge,” he said.
The exception remains restaurants that are heavily tourist-driven, which will likely keep the automated charge.
“There is a distinct difference between how Europeans and Americans tip,” McKelvey said, noting Europeans are accustomed to gratuities being automatically added to their bills.
Business owners looking to decrease the likelihood of the IRS auditing their tip reporting may enter into a Tip Reporting Alternative Commitment. Employers who enter into this agreement with the IRS agree to enforce policies and procedures, such as implementing a daily record of tips, and educate their employees about tip reporting, Armao said.
“In turn, the IRS agrees not to audit your tips unless there is a complaint or reason to,” he said.
Employers can also enter into a Tip Rate Determination Agreement, in which the IRS and business owner work together to calculate an agreed-upon rate for tips for each category of tipped employees. At least 75 percent of employees are required to participate and, in turn, the IRS again commits not to examine the employees’ tip income.
“It’s a win-win because it gives you audit protection,” Brenner said.