IRS Serves Up New Reporting Rules on Gratuities

In the past, tip reporting has been a problem for certain employers in the service industry and now the IRS has upped the ante.

History of Tipping

Employees who receive $20 or more in cash tips a month are required to report the amount to their employers by the 10th of the following month. Those who receive tips of less than $20 a month need not report it to their employers, but must still file the amounts on their income tax returns.

The cash tip category includes money received directly from customers, money from other employees under tip-sharing arrangements, and tips charged on credit and debit cards and distributed to the employee.

However, service charges that are added to a customer's bill don't constitute tips. Instead, they are treated as non-tip wages subject to Social Security and Medicare tax, as well as federal income tax withholding. In addition, employers cannot use these non-tip wages when computing the credit available for taxes paid on tip income under section 45B of the tax code.

The IRS cites several common examples of these service charges, sometimes referred to as automatic gratuities, or auto-gratuities including:

• Large party charges (restaurant);

• Bottle service charges (restaurant and nightclub);

• Room service charges (hotel and resort);

• Contracted luggage assistance charges (hotel and resort), and

• Mandated delivery charges (pizza or other retail deliveries).

Employees can use Form 4070A (Employee's Daily Record of Tips) to keep a daily record of their tips and Form 4070 (Employee's Report of Tips to Employer) to report their tips. Both forms may be found in IRS Pub. 1244 (Employee's Daily Record of Tips and Report to Employer). Alternatively, an employer may provide other means for reporting tips, such as an electronic system.

After receiving the necessary information, employers are responsible for paying their portion of Social Security and Medicare taxes, and collecting employees' portions of those payroll taxes and of the federal income tax withholding.

Finally, if an employer operates a large food or beverage establishment, it must file Form 8027 (Employer's Annual Information Return of Tip Income and Allocated Tips) each year. This applies to a business if tipping is customary, food or beverages are provided for consumption on the premises, and the business normally employs more than ten people who work more than 80 hours on a typical business day.

The New Rules

Now, restaurants or other establishments that commonly add automatic gratuities onto the bill for large parties face another tax headache. These gratuities are now treated as service charges unless an exception applies, resulting in extra payroll tax complications.

The changes stem from a 2012 IRS ruling narrowing the definition of "tips" for payroll purposes (Rev. Rul. 2012-18). In that ruling, the IRS said that non-discretionary charges to a customer are treated as wages unless the following four factors exist.

1. The payment is not compulsory;

2. The customer has the unrestricted right to determine the amount;

3. The payment is not the subject of negotiation or dictated by employer policy, and

4. The customer has the right to determine who receives the payment.

Initially, these rules were scheduled to take effect on Jan. 1, 2013, but the IRS was persuaded to postpone the effective date to this year to give businesses in service industries more time to modify their procedures. (IRS Announcement 2012-50)

The rule applies to automatic gratuities that are frequently included for larger parties. For example, suppose a restaurant automatically charges 18 percent for parties of ten people or more and states so on its menus. This has become a common practice in the restaurant industry to prevent waiters and waitresses from getting minimal or no tips on a large bill. The IRS carved out the new rules because it had long suspected that these gratuities were often underreported or not reported at all.

Significantly, the ruling requires changes to the way employers handle these gratuities. The payments now must be treated as wages and employers must withhold income tax. Employers must also factor this into the hourly pay rates of their employees.

Differences in state laws might further complicate pay rates. And, in contrast to tips, payroll taxes on service charges aren't eligible for the general business tax credit.

Payroll taxes aren't the only concern for employers under the new tip reporting rules. This also affects the pay rates for hourly employees. For instance, if automatic gratuities aren't figured into employees' hourly rates, their overtime pay may be inaccurate. Because restaurant workers are especially vulnerable to potential problems with wage and hour laws, the U.S. Department of Labor has vowed to carefully monitor the industry and promptly investigate any complaints. It is critical for payroll managers to remain diligent in observing all the rules, including minimum wage requirements and overtime payments.

Most employees aren't welcoming the changes. They now have to wait for their regular paychecks to effectively receive gratuities instead of pocketing the money on the day of the service. To counteract this result, some employers are allowing customers more flexibility concerning tips for large parties or foregoing automatic gratuities.

Get in compliance: Employers in service industries who aren't completely on board yet with these changes must conform immediately. The new rules should be reflected in accounting procedures, imposition of payroll taxes and withholding and wage hour requirements and computations. Coordinate these changes with other aspects handled by your payroll department or company.