Automatic Tipping: Impact of IRS Rules Change on the Hospitality Industry

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By Michael J. Donohue, Esq., and Jessica Glatzer
Mason, Esq.
 

Gardere Wynne Sewell LLP, Dallas, TX and Houston, TX

Starting in 2014, restaurants and other employers in the
hospitality industry will be subject to new IRS reporting and
withholding rules relating to automatic tips charged to large
groups of patrons.

Background.  Employees are
required to report cash "tips" of $20 or more to their employer
within 10 days after the end of the month when the tips are
received. Employers are required to collect income and payroll tax
on tips based on tips reported to them by employees. Cash tips
include: (i) tips received directly from customers by cash, credit
card or debit card; (ii) tips collected and distributed to an
employee by an employer; and (iii) tips received through an
employee tip sharing arrangement. The employer is not responsible
to withhold employee payroll taxes on unreported tips until a
notice and demand is made from the IRS.

IRS Ruling.  Recently, the IRS
issued Rev. Rul. 2012-18, 2012-26 I.R.B. 1032 (the "Ruling") to
address an employer's tax withholding and reporting of "mandatory
tips," which are often imposed by restaurants for parties larger
than six or eight customers. Unlike tips that subject the employer
to tax withholding and reporting to the extent disclosed by the
employee, the Ruling clarifies that automatic gratuities are
service fee wages that the employer is responsible for monitoring,
withholding and reporting to the IRS. The Ruling states whether a
payment is a tip or a service charge wage is a factual
determination, but absent one of the following criteria the payment
likely is characterized as wages (rather than a tip): (i) the
customer's payment must be made free from compulsion; (ii) the
customer must have the unrestricted right to determine the amount;
(iii) the payment should not be the subject of negotiation or
dictated by employer policy; and (iv) generally, the customer has
the right to determine who receives the payment. To illustrate this
determination, the Ruling posits an example where a restaurant
imposes a mandatory 18 percent charge for parties of six or more.
The Ruling concludes the amount is a "service charge" and thus
"wages" for federal tax withholding and reporting purposes,
provided the restaurant distributes the 18 percent charge to
employees. Conversely, if the restaurant merely includes sample tip
amounts on the bill, and the tip line is left blank, the amount the
customer adds to the bill is considered a "tip" for federal tax
purposes. IRS Announcement 2012-50 provides that the Ruling is
applicable to payments paid after 2013.

Other Possible Consequences.  The
designation of "mandatory tips" as wages may have not only
employment tax implications, but also wage rate implications since,
as wages, mandatory tips may impact the regular rate of pay for
hourly employees. If the mandatory tip amounts are not properly
incorporated into the employee's hourly rate, the employee's
overtime wages will be calculated incorrectly. This is of
particular importance because the Department of Labor has made the
restaurant industry a primary focus for its investigations. Citing
its belief that restaurant workers are especially vulnerable to
employer's non-compliance with wage and hour laws, the DOL has
stated that it is keeping a very close eye on the industry and will
diligently investigate employee complaints.  For this reason,
failure to comply with the Ruling may subject a restaurant employer
to intense scrutiny not only by the IRS, but also by the DOL, and
the investigation may expand beyond the scope of the Ruling into
many wage and hour areas, including minimum wage and overtime
classification.

Application to Hospitality
Industry.
 The Ruling potentially has significant
implications for businesses that have been treating "automatic
gratuities" as tips rather than wages. Employers should review
their reporting practices regarding mandatory tips. Commencing in
2014, restaurants and other hospitality businesses may decide to
discontinue their automatic gratuity policy for large groups to
avoid the additional bookkeeping and responsibilities imposed by
the Ruling. If you have any questions regarding this alert,
please contact Attorneys .

For more information, in the Tax Management Portfolios, see
Allman, 392 T.M.
, Withholding, Social Security and
Unemployment Taxes on Compensation,  and in Tax Practice
Series, see ¶5440, Employment Tax Withholding Requirements

© 2013 Gardere Wynne Sewell LLP