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Tips vs Service Charges: The IRS Changes the Game

It happens everywhere to restaurant patrons in large parties (six or eight or more):

the restaurant tacks on an automatic gratuity percentage so that math-compromised

guests don’t shaft the server(s) at the end of the meal. Tipping also helps to keep

menu prices stable and attract high quality servers. So even as the American

economy crawls slowly into a healthier place, the IRS ruling that an automatic

gratuity is really a service charge tosses the country’s wait staff a rotten tomato.


The difference between tips and service charges is significant because tips are not

subject to FICA (Federal Income Contributions Act) withholding and service charges

are. This new ruling classifies service charges as a wage rather than a free-will

payment made by a patron at the end of a meal. Ultimately, it means that while the

wait staff eventually get their portion of the service charge, it is deferred and added

into their wages with FICA, state and federal withholding taxes deducted.


To qualify as a tip or gratuity, a customer’s payment to a server must meet four

requirements:

  •  The patron makes the server’s payment of his or her own free will

  •  The patron decides the amount of the server’s payment

  •  The patron decides which server(s) are given an additional payment

  •  The payment made by the patron is not negotiated or set by the restaurant’s policy

Automatic gratuities, now considered service charges, flunk the tip test on all four

factors. So the service charge becomes part of the server(s) wages paid every week

or two weeks, not hard cash they take home that evening.


The new ruling also changes how restaurants, country clubs and other hospitality

enterprises handle their automatic and manual reporting for IRS purposes. The

ripple effect is potent as merchant services and hospitality management software

and terminals now must be adjusted to accommodate the IRS ruling.


Some restaurants are changing their employment model to pay servers a living

wage rather than providing a low hourly rate and expecting the rest of the server’s

money to come from serious hustle and schmooze. Still other restaurants are

avoiding the service charge issue by providing large parties with suggested gratuity

tables of 15 percent, 18 percent and 20 percent of the total check, then letting the

patrons make the ultimate decision on tipping themselves.


For more information about merchant services and hospitality management

systems, please call Mike Krause at 585-704-6453 or email him at

Mike@SalesSensePayments.com. Please also visit www.SalesSensePayments.com.

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