The Internal Revenue Service’s began enforcing Revenue Ruling 2012-18, which relates to the classification of tips as service charges, on January 1, 2014. Restaurant owners, managers and staff should understand what the IRS tips reporting rule entails.
Under the ruling, the agency now classifies automatic gratuities as service charges instead of tips. Accordingly, the IRS now treats service charges as regular wages, which means they must be reported for payroll tax withholding.
Previously, restaurants routintely charged automatic gratuity of, for example, 18-20 percent for parties of six to eight or more customers. Now, restaurants that do so will face the following consequences:
• A need to pay the higher minimum wage for their employees;
• A need to pay sales tax on automatic gratuities; and
• Loss of the FICA tip credit.
Clearly restaurant owners need to weigh the pros and cons of automatic gratuities. Restaurants, bars, nightclubs, etc. may continue to suggest what they deem a fair gratuity. But if they want to avoid the consequences, they should cease the practice of automatic calculations of tips and allow tip amounts to be at the discretion of their customers.
Restaurants that continue to add service charges to checks should follow these steps to ensure compliance with the IRS revenue ruling:
1. Secure IRS Form 407A, Employee’s Daily Record of Tips, and Form 4070, Employee’s Report of Tips to Employer, which are available in IRS publication 1244, and distribute them to the staff. Employers also have the option of creating their own form provided that it contains the following required information: employee’s name, address and Social Security number; employer’s name; period covered and date reported; total amount of tips received by the employee; and employee’s signature.
2. Employers must collect these forms and, with the guidance of their accountant, calculate the amount of Social Security and Medicare to withhold for the specific pay period on both an employee’s wages and reported tips. (Note: It is the employer’s responsibility to collect the employee’s portion of the Social Security and Medicare taxes, then remit them to the IRS.)
3. Businesses that serve food and beverages, have more than 10 employees and where tipping is common must, at the end of the year, file IRS Form 8027, which provides a summary of the business’ total sales, charged sales, charged tips and total reported tips.
Employees also have obligations under the IRS Revenue Ruling 2012-18. According to the IRS, employees should recognize that all tips they receive are income and therefore subject to federal income tax. Therefore, employees must report as income all tips they receive directly, charged tips paid to them by their employers and their share of any tips received under a tip-pool or tip-splitting arrangement they have with fellow workers in their reported gross income. Employees should also include as income, subject to tax, the value of any noncash tips they receive such as tickets, passes or other items of value.
To report their income correctly, the IRS advises that employees:
1. Keep a daily tip record.
2. Report tips to their employer.
3. Report all your tips on their income tax return.
There’s little doubt that the IRS is serious about enforcing its tips reporting rules. For their part, many restaurants recognize this and are taking measures to comply. Some chain restaurants, for which the stakes can get especially high, have opted to discontinue the automatic gratuity practice. Among them are Outback, Olive Garden and Carrabba’s. Independent restaurants too have decided it is in their best interests to simply abandon a policy of automatic gratuities believing the new rule sets up a no-win situation. “By the time the gratuities trickle through the ‘new’ system, servers are left with 12-14 percent or less. And that’s not at all worth the paperwork,” owner Lobster Trap owner Kim Murray told the Asheville, NC Citizen-Times. “It leaves management with the choice of losing money to take care of the server appropriately, or only give them what’s left after being taxed twice on the gratuity (service charge). No one wins in either instance.”
Adding fuel to the fire, the enforcement of IRS Revenue Ruling 2012-18 comes at a time when the hospitality industry is already being targeted by the Department of Labor for wage and hour rule violations. That is why it is especially critical that restaurant and hospitality business owners be prudent and diligent with respect to their regulatory compliance. As always, to mitigate risks, seek the guidance of trusted advisors–accountants and attorneys.
Anil Melwani, CPA, is managing partner with 212 Tax & Accounting Services.