Effective January 1, 2014, IRS Revenue Ruling 2012-18 provides restaurants guidance concerning the use of automatic gratuities, or ‘service charges’ charged on the basis of table size.
Generally, gratuities are not includable in the income of the establishment and are reported separately by employees. The revenue ruling states that ‘auto grats’ are considered fees collected by the restaurant and should be included in income. The resulting pay-out to employees should be added to wages and taxed accordingly.
The revenue ruling defines a gratuity as one which is paid out subject to the following:
- the payment must be made free from compulsion;
- the customer must have the unrestricted right to determine the amount;
- the payment should not be the subject of negotiation or dictated by employer policy; and,
- generally, the customer has the right to determine who receives the payment.
The Tip Tax Credit is a credit available to restaurants which promote proper tip reporting and participation by tipped employees. This credit can be quite significant, representing the employer’s share of social security and medicare related to tips in excess of the minimum wage. Service charges are not eligible for the tip tax credit.
The NAEA e-Alert, a weekly e-newsletter for Enrolled Agents comments, “expect restaurants, particularly larger chains, to dispense with automatic gratuities. As an EA, you can see the advantage to the employer here vis-à-vis the tip credit.”