If You Treat Service Charges as Tips, You Invite IRS Scrutiny and Possible Tax Deposit Penalties

October 22, 2012|Amy Bradley

Do you add a gratuity to the amount you charge customers? The IRS says that more restaurants have been adding an “auto-gratuity” or service charge on customers’ checks as they attempt to stabilize income received by their staff during these difficult economic times.

At a recent payroll industry teleconference, the IRS explained how the payroll tax deposit rules on service charges are different from those for tips, and warned that they will be looking more closely at Form 941, “Employer's Quarterly Federal Tax Return” and Form 8027, “Employer's Annual Information Return of Tip Income and Allocated Tips” for these items. Many restaurants are currently reporting them as tips when they should be reported as service charges. Specifically, the IRS will attempt to identify a decrease in tips with a corresponding increase in the amount reported as wages.

In general, the rules define a gratuity as a service charge if the customer is not able to set the amount of the gratuity or choose who receives it. The service charge belongs to the restaurant as additional income. If management chooses to share the service charge with the server, it becomes cash wages earned by the server on the day that he or she receives it. The service charge is not a tip.

Similar to the rules for paying workers in cash, these paid-out service charges could trigger a payroll tax deposit requirement that is not in sync with your normal tax deposit due date, causing exposure to IRS tax deposit penalties. Not only that, cash wages are subject to legal withholdings, such as garnishments and child support, which create more detailed recordkeeping work. One way to avoid the extra reporting and deposit predicaments is to hold these service charges and pay them out on the server’s normal pay date.

The IRS also discussed “tip-outs” in the teleconference. A common practice in the industry, tip-outs occur when servers share gratuities they receive with other support staff members, such as busboys. The IRS said that the amount of a service charge that a server gives to a busboy could possibly be included in the busboy’s taxable income. However, the server is still subject to payroll tax withholdings on 100% of the service charge, in spite of sharing some of it with the busboy. You can avoid the problem of doubling up on payroll taxes on the amount given to the busboy if you handle the service charge and split it between the server and the busboy before it gets paid out.

Please contact Amy Bradley at 800-236-2246 if you need more information.