Tips are a staple of the restaurant industry and are currently under scrutiny as there is a wave of frustration with customers that is resulting in less tipping or no tipping at all. This has a wide array of impact to restaurants, from the employees, in both the front and back of the house, all the way up to the owners and investors of the restaurant.
Recent surveys are showing that nearly 6 in 10 people have a negative view on tipping. Specifically, significant groups of customers are annoyed at pre-entered tip screens or believe that tipping is generally out of control. Especially since the Pandemic, the amounts have ballooned.
This is leading restauranteurs and business owners to contemplate a change to their tip structure from traditional tipping, to implementing a standard service charge. There are important distinctions that restauranteurs need to understand from a tax perspective as the IRS distinguishes between tips and service charges in very different ways and with very different tax consequences.
Understanding Tips vs. Service Charges
Tips are amounts paid by customers either in cash or through electronic payment or amounts received from other employees paid out through tip pools or tip splitting. In order to be considered a tip, it must be paid voluntarily by the customer, the customer has no restriction to the amount of the tip that is made, and the customer has the right to determine who may receive the tip payment. In contrast, a service charge is considered an automatic gratuity, is reported as wages, and the restaurant dictates who may receive the wages and how much those wages may be. This usually is charged with large parties, banquets, catering, and in recent years many restaurants have started instituting a flat rate on top of its bill automatically in lieu of tipping.
You may have recently visited a restaurant where, in some states, there is a requirement at the onset of the restaurant experience for the waitstaff to inform you of the service charge ahead of time. One recent experience I had was 22% of the total food and drink spend would be calculated as the service charge.
Tax Reporting Differences
The IRS distinguishes between the two with respect to how tips are reported and the tax impact to the employees. Service charges or automatic tips are reported as non-tip wages paid to the employee. The restaurant can dictate how much, if any, of the service charge is kept. Only the amounts distributed to employees are non-tip wages to those employees. All cash tips and noncash tips should be included in an employee’s gross income and subject to federal and state income taxes but require certain reporting by the employee to the employer.
When the cash tips are reported to the employer, the restaurant should withhold the employees share of Social Security and Medicare taxes on these reported tips. This is an important distinction with cash tips as this leads to a valuable tax credit that Congress put in place for restaurants and other industries where tipping is prevalent. In order to provide an incentive for these businesses to get their employees to report tips, the restaurant or the owners’ of the restaurant (depending on how the company is structured), may receive a tax CREDIT that can reduce income tax liability on a dollar-for-dollar basis for the amount of FICA that they were required to pay on the tips received. In a service charge setting, these charges do not qualify for the credit since they are not considered tips
Before considering a change in the restaurant’s operations, you should consult with a tax advisor that has strong restaurant experience to understand the potential impact to you and your restaurant. Conversely, if you are reporting tips, it is important to ensure your wage reporting properly reports social security tip wages in order to get this credit. A good and knowledgeable payroll service should be aware of the tip reporting requirements.
Contact Us
For more information on this topic, please contact a member of Withum’s Restaurant Services Team.
