IRS reviews differences between tips and service charges

Employer Reminder: Reporting Tips versus Service Charges; Key Differences Between Categories Affect Employees, Tax Reporting.

IRS has updated a fact sheet and a tax tip topic that explain the differences between tips and service charges. Tips are subject to special FICA tax rules while service charges must be treated as wages and not as tips.

What are tips?
IRS explains that a tip is a discretionary (optional or extra) payment determined by a customer that employees receive from a customer. An employee can receive a tip in cash directly from customers or via an electronic settlement or payment (this includes a credit card, debit card, gift card, or any other electronic payment method). A tip also includes the value of any noncash tips, such as tickets, or other items of value; and tip amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip-sharing arrangements.

In general, the following factors characterize a payment as a tip:
• 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 negotiation or dictated by employer policy; and
• The customer should generally have the right to determine who receives the payment.
Absent these factors, the payment is likely a service charge (see below).

OBSERVATION: The above factors indicating that a payment is a tip are well established. They were first set forth by IRS in Rev Rul 59-252, 1959-2 CB 215 .

How tips are reported. Employees must report to their employer all cash tips received, except for 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 the employer, and tips received from other employees under any tip-sharing arrangement. Non-cash tips (e.g., passes, tickets, etc.) from customers are not reported to the employer. All cash tips and non-cash tips are includable in an employee’s gross income and are subject to federal income taxes.
Both directly and indirectly tipped employees are required to report tips to their employer. A “directly tipped employee” is one who receives tips directly from the customer, including tips that are turned over to a tip pool. Examples include servers, bartenders and hairstylists. An “indirectly tipped employee” is one that does not normally receive tips directly. Examples include bussers, cooks and salon shampooers.

Employers must retain employee tip reports, withhold employee income taxes and the employee share of Social Security and Medicare taxes from wages paid and reported tips, and then report this information to IRS. In addition, employers must pay the employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees, as well as the reported tip income.
Tips reported to the employer by the employee are included on Form W-2 in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips). Employers must enter the amount of any uncollected Social Security tax and Medicare tax in Box 12 of Form W-2.

What are service charges?
Amounts an employer requires a customer to pay are service charges. This is true even if the employer or employee calls the payment a tip or gratuity.
Examples of service charges commonly added to a customer’s check include:
(1) large dining party automatic gratuity;
(2) banquet event fee;
(3) cruise trip package fee;
(4) hotel and resort room service charge;
(5) contracted luggage assistance charge at hotels or resorts; and
(5) bottle service charge at nightclubs or restaurants.
Illustration : A restaurant’s menu explains that an 18% service charge will be added to all parties of six or more. The bill for a party of 8 includes an amount on the “tip line” equal to 18% 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 ).
How service charges are reported. Generally, service charges are reported as non-tip wages paid to the employee. If an employer keeps a portion of the service charges, only the amounts distributed to employees are non-tip wages.
Employers who distribute service charges to employees should treat them the same as regular wages. They are subject to social security tax, Medicare tax, and federal income tax withholding. IRS’s revised topic on Tips-Withholding and Reporting, reminds employers that they can’t use these non-tip wages when computing the special credit available to employers under Code Sec. 5B because these amounts aren’t tips. IRS’s new fact sheet notes that distributed service charges must be included in Boxes 1, 3 (Social Security wages), and 5 of Form W-2.