The Internal Revenue Service passed a law in 2012 that takes effect January 1, 2014 that has an impact on businesses that charge automatic gratuities also described as service charges. According to the regulation, service charges must be characterized as wages and will have an effect on overtime rates as well as payroll taxes.
To be considered a tip, the payment must meet these requirements:
- The payment must be “free from compulsion”
- The customer must have the unrestricted right to determine the amount
- The payment should not be subject to negotiation or dictated by employer policies
- The customer has the right to determine who receives the payment
So what does this mean? If a business has a policy of automatically adding a charge to the bill of parties over a certain amount (many locations are 6 or 8 guests), this is seen as a service charge. However, if a bill show sample calculations for tips (15%, 18% and 20%) allowing the customer to decide how much to pay, this is a tip.
Service charges are seen as income to the business, not the server, so when paid to the employees, these payments are subject to all federal payroll taxes (social security, Medicare, and income tax withholding ) as well as any state taxes that would normally apply as well. Failure to properly withhold from service charges is the responsibility of the employer, and the employer may be held liable for any shortfall in withholding.
With this change, rates for overtime will be affected. When calculating overtime, add any service charges earned to wages divided by the number of hours worked to calculate the effective hourly rate. If this seems complicated and you don’t want to have to keep track of if payments are tips or service charges, do not charge any automatic gratuities. Allow the customer to determine how much the server receives.
For more detailed information on this topic, see http://www.irs.gov/irb/2012-26_IRB/ar07.html.