Employers in the restaurant, hotel, casino, and other service industries must comply with laws associated with tips, including the Fair Labor Standards Act and the Internal Revenue Code. To assist them, the IRS issued Fact Sheet 2017-8 that explains the differences between tips and service charges for tax purposes.
Examples from the IRS
Example: A restaurant’s menu specifies that an 18% charge will be added to all bills for parties of six or more customers. The bill for food and beverages for one customer’s party of eight includes an amount on the “tip line” equal to 18% of the price for food and beverages and the total includes this amount. The restaurant distributes this amount to the waitresses and bus peoples. Under these circumstances, the customer didn’t have the unrestricted right to determine the amount of the payment because it was dictated by the restaurant/ employer. The 18% charge is not a tip under the Internal Revenue Code. Instead, the amount included on the tip line is a service charge.
Example: A restaurant includes sample calculations of tip amounts beneath the signature line on its charge receipts for food and beverages provided to customers. The actual tip line is left blank. A diner’s charge receipt shows sample tip calculations of 15%, 18% and 20% of the price of food and beverages. The customer inserts the amount calculated at 15% on the tip line and adds this amount to the price of food and beverages to compute the total. Under these circumstances, the customer was free from compulsion to enter any amount on the tip line or leave it blank. The restaurant and the customer didn’t negotiate the amount, nor did the restaurant dictate the amount. Therefore, the amount is a tip under tax law.
— Source: IRS Revenue Ruling 2012-18
Are the Payments Discretionary?The IRS emphasizes that tips are discretionary (optional or extra) payments determined by a customer that employees receive from customers. Tips include:
- Cash tips received directly from customers,
- Tips from customers who leave a tip through electronic settlement or payment (this includes a credit card, debit card, gift card or any other electronic payment method),
- The value of any noncash tips, such as tickets, or other items of value, and
- Tip amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip-sharing arrangements.
In general, the following factors characterize a payment as a tip:
- The payment must not be compulsory.
- The customer must have the unrestricted right to determine the amount. For example, the customer can decide to leave 15%, 20%, some other amount — or nothing.
- The payment shouldn’t be the subject of negotiation or dictated by employer policy.
- The customer should generally have the right to determine who receives the payment.
“Absent these factors, the payment is likely a service charge,” the IRS stated.
Service Charges Are Required by Customers
Amounts an employer requires a customer to pay are service charges. This is true even if the employer or employee calls the payment a tip or gratuity. Examples of service charges commonly added to a customer’s check include:
- Large dining party automatic gratuity,
- A banquet event fee,
- A cruise trip package fee,
- Hotel room service charges, and
- Bottle service charges at nightclubs and restaurants.
Generally, service charges are reported as non-tip wages paid to the employee. Some employers keep a portion of the service charges. Only the amounts distributed to employees are non-tip wages.
Reporting Requirements for Tipped Employees
Employees must report to their employer all cash tips received, except for tips in a month that total less than $20. Cash tips include tips received from customers, charged tips (for example, credit and debit card charges) distributed to the employee by his or her employer, and tips received from other employees under any tip-sharing arrangement.
Noncash tips (in other words, tips in any medium other than cash, such as passes, tickets, or other goods or commodities) aren’t reported to the employer. All cash tips and noncash tips are includable in an employee’s gross income and are subject to federal income taxes.
Direct and Indirect
Both directly and indirectly tipped employees are required to report tips to their employers. A “directly tipped employee” receives tips directly from the customer, including tips that are turned over to a tip pool. Examples include servers, bartenders, and hairstylists.
An “indirectly tipped employee” doesn’t normally receive tips directly. Examples include employees who “bus” or clear tables, cooks and salon shampooers.
Employers of tipped employees are required to:
- Retain employee tip reports,
- Withhold employee income taxes and the employee share of Social Security and Medicare taxes from wages paid and reported tips,
- Pay the employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees plus reported tip income, and
- Then report this information to the IRS.
Tips reported to the employer by an employee must be included on Form W-2 in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips). Employers must enter the amount of any uncollected Social Security tax and Medicare tax in Box 12 of Form W-2.
Reporting Requirements for Service Charges
Employers that distribute service charges to employees should treat them the same as regular wages for tax withholding and filing purposes. The IRS notes that distributed service charges must be included in Boxes 1, 3 (Social Security wages), and 5 of Form W-2. Employers can’t use these non-tip wages when computing the special credit available to employers under Internal Revenue Code Section 45B.
For more information about your situation, contact your tax advisor or payroll professional.