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By Jessica Glatzer Mason and Tax Partner Michael J. Donohue
In 2014, restaurants and other employers in the hospitality industry will be subject to new IRS reporting and withholding rules relating to automatic tips charged to large groups of patrons.
Background. Employees are required to report cash “tips” of $20 or more to their employer within 10 days after the end of the month when the tips are received. Employers are required to collect income and payroll tax on tips based on tips reported to them by employees. Cash tips include: (i) tips received directly from customers by cash, credit card or debit card; (ii) tips collected and distributed to an employee by an employer; and (iii) tips received through an employee tip sharing arrangement. The employer is not responsible to withhold employee payroll taxes on unreported tips until a notice and demand is made from the IRS.
IRS Ruling. Recently, the IRS issued Rev. Rul. 2012-18 (the “Ruling”) to address an employer’s tax withholding and reporting of “mandatory tips,” which are often imposed by restaurants for parties larger than six or eight customers. Unlike tips that subject the employer to tax withholding and reporting to the extent disclosed by the employee, the Ruling clarifies that automatic gratuities are service fee wages that the employer is responsible for monitoring, withholding and reporting to the IRS.
The Ruling states whether a payment is a tip or a service charge wage is a factual determination, but absent one of the following criteria the payment likely is characterized as wages (rather than a tip): (i) the customer’s payment must be made free from compulsion; (ii) the customer must have the unrestricted right to determine the amount; (iii) the payment should not be the subject of negotiation or dictated by employer policy; and (iv) generally, the customer has the right to determine who receives the payment.
To illustrate this determination, the Ruling posits an example where a restaurant imposes a mandatory 18 percent charge for parties of six or more. The Ruling concludes the amount is a “service charge” and thus “wages” for federal tax withholding and reporting purposes, provided the restaurant distributes the 18 percent charge to employees. Conversely, if the restaurant merely includes sample tip amounts on the bill, and the tip line is left blank, the amount the customer adds to the bill is considered a “tip” for federal tax purposes. IRS Announcement 2012-50 provides that the Ruling is applicable to payments paid after 2013.
Other Possible Consequences. The designation of “mandatory tips” as wages may have not only employment tax implications, but also wage rate implications since, as wages, mandatory tips may impact the regular rate of pay for hourly employees. If the mandatory tip amounts are not properly incorporated into the employee’s hourly rate, the employee’s overtime wages will be calculated incorrectly. This is of particular importance because the Department of Labor has made the restaurant industry a primary focus for its investigations. Citing its belief that restaurant workers are especially vulnerable to employer’s non-compliance with wage and hour laws, the DOL has stated that it is keeping a very close eye on the industry and will diligently investigate employee complaints. For this reason, failure to comply with the Ruling may subject a restaurant employer to intense scrutiny not only by the IRS, but also by the DOL, and the investigation may expand beyond the scope of the Ruling into many wage and hour areas, including minimum wage and overtime classification.
Application to Hospitality Industry. The Ruling potentially has significant implications for businesses that have been treating “automatic gratuities” as tips rather than wages. Employers should review their reporting practices regarding mandatory tips. Commencing in 2014, restaurants and other hospitality businesses may decide to discontinue their automatic gratuity policy for large groups to avoid the additional bookkeeping and responsibilities imposed by the Ruling.
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