On April 25, 2017, the IRS updated a fact sheet explaining the differences between tips and service charges. Service charges are generally wages, and they are reported to the employee and the IRS in a manner similar to other wages. On the other hand, special rules apply to both employers and employees for reporting tips. Also, note that mandatory gratuities associated with a taxable sale are subject to sales tax in many states, whereas voluntary gratuities are not considered taxable sales.
Distinguishing Tips from Service Charges
The IRS defines tips to 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
- Tip amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip sharing arrangement
According to the IRS, four factors are used to determine whether a payment qualifies as a tip. Normally, all four must be present in order to have a tip. The factors are:
- 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 negotiations or dictated by employer policy
- The customer has the right to determine who receives the payment.
Illustration: A restaurant's menu explains that an 18 percent service charge will be added to all parties of six or more. The bill for a party of eight includes an amount on the “tip line” equal to 18 percent of the price for food and beverages, the total includes this amount, and the restaurant distributes this amount to the waitresses and bussers. The amount included on the tip line is a service charge dictated by the restaurant, not a tip (see Rev. Rul. 2012-18, 2012-26 IRB 1032).
Employee Reporting Requirements
Employees must report to their employer all cash tips received except for the tips from any 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 (that is, tips received by an employee in any other medium than cash, such as passes, tickets, or other goods or commodities) from customers are not reported to the employer
- A server may deduct the portion of tips that he or she turns over to co-workers
Where an employee fails to keep records of his or her tips or reports only nominal amounts of tips, the IRS will assert taxes on estimated tips and a penalty equal to 50 percent of those taxes unless the employee can provide a satisfactory explanation showing that the failure was due to reasonable cause and not due to willful neglect.
Employers are required to retain employee tip reports, withhold income taxes and the employee share of Social Security and Medicare taxes from the wages paid, and withhold income taxes and the employee share of Social Security and Medicare taxes on reported tips from wages (other than tips) or from other funds provided by the employee. In addition, employers are required to pay the employees as well as the reported tip income.
The employer of a “large food or beverage establishment” must allocate as tips among employees performing services during any payroll period who customarily receive tip income an amount equal to the excess of 8 percent of the gross receipts of such establishment for the payroll period over the aggregate amount reported by such employees to the employer for such period. A large food or beverage establishment means any trade or business (or portion thereof) which provides food or beverages, with respect to which the tipping of employees serving food or beverages by customers is customary, and which normally employed more than 10 employees on a typical business day during the preceding calendar year.
Service charges are also considered to be income by the IRS, but, by contrast to the rules for tips, the restaurant, not the employee, is obligated to report the service charge income paid to its employees. Also, unlike with tips, the employer must withhold payroll taxes before paying any service charges to its employees. If a payment to an employee is considered a tip, therefore, no withholding is required before payment to the employee, but, if the payment is considered a service charge, then the restaurant must withhold payroll taxes before paying it to the employee.
Credit for Employer Share of Taxes Paid
Social Security and Medicare taxes paid by an employer on employees’ tip income may be eligible for a federal tax credit. The credit is available with respect to taxes paid on tips received from customers in connection with the providing, delivering, or serving of food or beverages for consumption, if it is customary for customers to tip the employees. No credit, however, is allowed to the extent tips are used to meet the federal minimum wage rate.
Julian A. Fortuna is a partner at Taylor English Duma LLP (Atlanta) in the Tax and Corporate and Business practices and he focuses on domestic and international tax planning and tax controversy matters.