Albeit it’s been over 7 years since the IRS enforced the Revenue Ruling 2012-18, there’s still confusion among restaurant owners. This ruling defines tips vs service charges, and clarifies the tax implications of each.
Generally, service charges are applied to ensure the certainty of tips for tipped employees serving large groups. But some eateries are slowly moving away from the tip model. The distinction between tips vs service charges is important. In fact, they have legal implications and materially affects tax reporting for both employer and employee.
Defining Services Charges vs Tips For Tax Purposes
If any of the below doesn’t apply, then a gratuity amount paid in excess of the meal cost may be a service charge:
- Customer must have the freedom to determine the amount
- The payment must not be dictated by employer policy or the subject of negotiation
- Payment must be made free from compulsion
- The customer has the right to determine who receives the payment
Of course, all circumstances and surrounding facts must be considered. But there’s not much gray area when distinguishing tips vs service charges. Consequently, if the payment is not the customer’s decision, then it is not a tip. For example, an imposed 20% service charge for groups of 12 or more is considered a service charge.
Why? Because it’s required by the eating establishment. On the other hand, a suggested tip line is consider tips and not service charges. And this is because the tip and the amount are the customer’s decision.
But why does this matter?
How Tips vs Service Charges Affect Sales Tax
Sales of hot prepared food are subject to California sales tax, no matter where the food is consumed. Thus, service charges are taxable as well. For instance, a customer purchases $800 of food and drinks, subject to 18% gratuity. They will pay sales tax on $944 instead of $800.
Statewide sales tax in California is 7.25%. Therefore, this would result in an additional $10.44 in sales tax on an $800 order. Obviously, this differs from a tipping model, where customers calculate tips on the order not including service charges.
Classification and Rights
Under the Fair Labor Standards Act, tips are the property of employees. Employees can voluntarily participate in a tip sharing agreement amongst themselves. Usually, this is done to ensure the tips are split fairly between their team.
In general, the employers typically facilitate this arrangement by collecting the tips and calculating the split. Afterwards, the amounts are distributed to employees in a systemized manner. This process also ensures that employees are reporting tips to their employer for tax purposes.
If tips are collected and distributed as discussed above, they are recorded as a liability on the restaurant’s books. After paying out the tips, the liability is reduced. Thus, the P&L is not affected by tips. Unfortunately, this is a common misunderstanding among new restaurant owners and similar establishments.
Conversely, service charges are property of the employer. Service charges are distributed to employees at the employer’s discretion. As such, they are reported as revenue on the P&L statement. But the amount paid to employees are recorded as an expense on the P&L. It’s easy to see how restaurants and similar establishments incorrectly process service charges like tips for payroll and P&L reporting.
Unless the total amount of tips is less than $20, employees must report all tips to their employer. The employer is required to report such tips plus employee wages earned to the IRS. Generally, this is done through payroll tax filings such as Form 8027, 941s, etc. The employee is then subject to income tax and FICA on these earnings. Also, the employee pays state and federal unemployment on these earnings.
Nowadays, most tips are charged to a credit card. So, this reporting process is more streamlined and facilitated by the eatery using their Point of Sale system. If an employee does not report tips to their employer, the employee is liable for their share of FICA. And also liable for income tax on those tips, not the employer.
The difference between tips vs service charges can have significant tax and legal implications. The systems, policies, and procedures should be implemented to ensure managers are reporting this information correctly. Notices and disclosures should be provided to employees so that they are fully aware of payment policies. If you’re interested in accounting guidance, please feel to contact us.