The Internal Revenue Service recently issued guidelines on service charges and tips that impact a variety of industries.  The IRS plans stricter compliance with rules that primarily govern restaurant industry gratuities, including service charges incorrectly reported as tips, an agency official said August 3rd during a payroll industry conference call.

There are key differences between tips and service charges, which employers should know to avoid incorrect payroll reporting, said Dan Lauer, program manager for the IRS National Tip Reporting Compliance Program.  IRS auditors plan to look at a payment's substance rather than its form when examining reporting compliance.

The use of service charges, also known as auto-gratuities, has increased in a less-than-robust economy, ensuring that employees receive at least the minimum wage, Lauer said.  Otherwise, employers are required to make up the difference between gratuities and the minimum wage as required by the Fair Labor Standards Act.  However, employers may not be aware that service charges should be reported as wages and not tips, he said.

Upon discovering a reporting gap for tips and service charges, the IRS released Revenue Ruling 2012-18 and Announcement 2012-25 to address evolving business practices and a lack of detailed IRS guidelines on tips and service charges, he said.

The revenue ruling applies to more than food and beverage service operators, Lauer said.  Many industries use tips or service charges, such as delivery businesses, hotels and resorts, and the cosmetology industry, he said.

Distinction Made Between Tips & Service Charges

Whether a payment is a tip is determined by the facts and circumstances related to the payment and not by the employer's or employee's designation, Lauer said.  For a payment to be a tip it must be voluntary, of an amount determined by the customer, not required by the employer, and received according to whom the customer dictates.  A mandatory service charge or gratuity on the customer's bill is considered an ordinary wage payment rather than a tip.

The revenue ruling used examples to show both ends of the spectrum for service charges, Lauer said.  According to the ruling, if a restaurant requires a nonnegotiable 18 percent gratuity charge for parties of at least six, then the gratuity is a service charge and should be treated as wages.

However, if a restaurant includes suggested amounts for different tips on a bill but leaves the tip line blank, the payment is a tip because the customer ultimately can decide the amount, the revenue ruling said.  Employers can take similar steps to make a service charge a tip, Lauer said, such as putting a line on a bill that allows a customer to alter the service charge.

Increased identification of service charges can affect tip outs, Lauer said.  Tip outs occur when directly tipped employees distribute some of their tips to indirectly tipped employees, including bartenders, kitchen workers, and busboys.  If a tip out is appropriate for a service charge, employers should remember that a service charge retains its identity as wages throughout the tip out and it should be reported as wages, he said.

Separation of those gross receipts subject to tipping and those subject to service charges is vital to staying in reporting compliance, Lauer said.  Employers should set up point-of-sale systems so that they identify which receipts have service charges and which have tips, he said.

During the 2013 tax filing season, IRS will be looking for “substance versus form” when determining compliance with the new guidance, Lauer said.  If an IRS auditor determines that a tip is a service charge, the finding could have a significant impact on an employer's employment tax liability because the payment would be similar to an employer paying an employee in cash, he said.

An Increase in Gross Wages and a Decrease in Tips

As employers start to apply the revenue ruling's guidance, IRS expects the amount of tips reported on Forms 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, and Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, to decrease and the amount of wages reported on the forms to increase because it expects more payments previously identified as tips to be reported as service charges, he said.  The increased reporting of service charges is also expected to affect tip allocation because of a decrease in tips and an increase in gross wages, he said.

Payroll departments and clients should discuss the expected changes to ensure compliance, Lauer said.  Confusion often arises between businesses and payroll providers about who is responsible for filing the Form 8027, so payroll also should clarify who has responsibility for filing the form, he said.

Employers should educate employees on whether certain payments are tips or service charges so that employees do not incorrectly report service charges as tips, he said.  If they do, service charges could be double reported, he said.

Most of the text for this blog article comes from the Bloomberg BNA Payroll Administration Guide Newsletter published on August 15, 2012, Volume 23 Number 17. Additional links have been added to provide more information and resources.