Restaurant Service Charges May Not Be Tips for Tax Reporting Purposes

May 31, 2016

Many people believe that tips and service charges are exactly the same. Of course it’s no problem if customers think of them as the same, but for tax reporting purposes they are very different. Service charges added to a customer’s bill are not necessarily considered tips. They are deemed to be business income for tax and financial accounting purposes even if you pay them to your employees.

What are service charges for a restaurant?

Restaurants sometimes add a certain percentage as a service charge to the bill on carryout orders, or to the bill for larger groups dining at the restaurant. Although customers generally pay these service charges in lieu of a tip, technically they are not tips because the amounts are not at their discretion.

If you choose to pay service charges to your employees, they are considered tips for purposes of satisfying your minimum wage and overtime obligations under the Fair Labor Standards Act (FLSA). It is not necessary to pay such service charge amounts on the day of service. For employees who also receive traditional tips, consider those tips in determining whether they are tipped employees and in applying the tip credit. For employees who do not receive traditional tips, you must pay their entire minimum wage and overtime as required by the FLSA whether or not you pay service charges to them.

You can wait to decide whether to pay service charges to your employees until the normal payroll cycle. Doing so will add them to wages, making those funds available to offset taxes and deductions such as garnishments and insurance.

Include service charges in gross receipts

Whether you pay out service charges as tips or keep them as business income, you must include them in employer gross receipts. If you pay all or a portion of them to employees after the date of service, then they will be included in your deduction for wages, which will effectively reduce your gross receipts.

Remember to notify your employees about how you handle service charges. If you pay some or all of these charges to your employees, please consider using a separate earnings code so it will be easier to understand what actually occurred.

Use a simple calculation to help decide about allocating

On Form 8027, “Employer’s Annual Information Return of Tip Income and Allocated Tips,” remember to remove the sales and carryout sales (also called nonallocable receipts) that have a service charge of 10% or more from gross receipts of food and drink sales for the allocated tips calculation. Start out with gross receipts of food and drink sales, subtract nonallocable receipts, and then multiply the result by 8%. If the total tips (remember to exclude service charges) reported by employees are less than the 8% calculated amount, then you will probably need to allocate tips among your tipped employees.

Please contact your Schenck advisor if you have any questions related to this topic.