The IRS recently released Revenue Ruling 2012-18 providing guidance on how to determine the difference between tips and service charges. They also released Announcement 2012-25 to its examiners to assist them when performing audits in this area. This is not new guidance as the IRS previously ruled in this area back in 1959 (Rev. Rul. 59-252).
The distinction between tips and service charges is important because tips are eligible for the FICA Tip Credit and service charges are not. Additionally, because service charges are wages under these rules, the payroll reporting is different for tips and service charges.
To determine if a payment is a service charge or a tip, we look at the definition of a tip under IRS rules. A tip will have the following characteristics:
- 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.
- The customer has the right to determine who receives the payment.
The absence of any one of these factors indicates that the payment is a service charge and not a tip. Service charges are required to be reported as wages, and all applicable payroll tax withholding is required. Service charges should not be included in any calculation that arrives at an hourly tip rate or any other tip rate determination method. This may be relevant for any business participating in the voluntary tip compliance program.
An example of a service charge is when a restaurant adds a certain stated percentage to a customer’s bill when 6 or more people are in the party. The stated amount automatically added to the bill in this case is a service charge, not a tip. Any additional amount added by the customer over and above the stated percentage would be a tip. Another example would be the service charges typically added to a customer’s bill in the case of a banquet event.
Taxpayers are required to account for service charges separately from tips. Business systems, whether manual or automated, need to be configured in such a way that these amounts can be accounted for in the normal course of business.
If the IRS audits your business and finds that amounts have been misclassified as tips, they will propose adjustments to Form 941 which in turn may require a change to the employer credits for FICA taxes paid reported on Form 8846.
Businesses should ensure that they are complying with these rules. The fact that the IRS has recently issued a ruling in this area indicates that increased scrutiny may be coming in the near future.