IRS Changes Restaurants’ Automatic Gratuity Practice

In January 2014, the Internal Revenue Service (IRS) changed the way automatic gratuity is handled in that tips automatically included on a customer’s bill is now considered a service charge. This “service charge” is handled as a wage, rather than a tip, for tax purposes. There will be a significant penalty to those restaurant owners who do not follow this new policy accurately. 

According to "Tips for Restaurants on the IRS Automatic Gratuity Rule," by Nation’s Restaurant News:

“To be considered a gratuity or tip for tax and wage purposes, a customer’s payment must satisfy four factors:

• The customer makes the payment free from compulsion;

• The customer has the right to determine the amount;

• The payment is not the subject of negotiation or dictated by an employer’s policy;

• Generally, the customer has the right to determine which employee receives the payment.”

In order to bypass the changes this new automatic gratuity regulation produces and to replace the extra income tips once provided, some restaurants that are doing away with tips altogether are increasing their wait staff’s wages and the cost of meals on the menu.  On the other hand, several restaurants are sticking with the tipping-method in order to keep menu prices down. One way to encourage tipping, while abiding by the new regulation, is to provide customers with gratuity calculations on the bill.

Clearly this is a big change for restaurant owners in terms of payroll. Two major foreseeable changes are as follows:

1) Restaurants that continue to automatically add gratuity, now have to keep up with the constant changes and calculations in hourly wages that service charges bring. The hourly rate is not so consistent any more since it could change hour-to-hour, employee-to-employee.

2) Another issue revolves around the FICA tip. Essentially, if automatic tips are considered services charges, then restaurants are no longer eligible for the tip credit.

Several changes ensue for restaurant owners and their staff based on the new ruling under the IRS. While some of it can be confusing, we hope that this will help fill in some gaps. For more information on the details of the automatic gratuity change, as well as suggestions for restaurant owners, please check out this article.