Partners at Habif, Arogeti & Wynne, LLP
It’s a common practice in the restaurant industry to include an automatic gratuity on checks for parties of a certain number. An 18 percent gratuity on parties of eight or more is fairly typical. But a new IRS rule is causing restaurants to rethink that practice.
Beginning in January and coming on the heels of strikes in favor of a higher minimum wage, the IRS will now classify automatic gratuities as service charges. Unlike tips, service charges are treated as regular wages and are subject to payroll tax withholding.
Automatic gratuities were originally put in place to ensure that servers, who typically have an hourly wage below the federal minimum and live off their tips, don’t get stiffed on large tables. But with the change in how the IRS treats those gratuities, restaurant servers may support removal of the practice in order to keep receiving all of their tips at the end of a shift.
The new rule doesn't just have ramifications for wait-staff. Restaurants themselves will have to determine how best to handle the new rule, including the cost of additional paperwork or payroll software to factor automatic gratuities into pay. Atlanta restaurant company Here to Serve already has their IT department looking into their choices. “We are currently exploring all options,” says Debbie Horn, Controller/CFO. “We want to accept auto gratuities, but only if they can be programmed as an additional and separate wage, to be held and taxed until the next payday. Our goal is to best accommodate all parties affected by this new ruling, especially our employees. We also want easy submission of compliant reportings to the IRS, while streamlining in-house operations. We remain optimistic that these goals can be accomplished. However, if the added programming becomes untenable, so may auto gratuities.”
Local restaurants aren’t the only ones weighing their options. According to the Wall Street Journal, Darden Restaurants, which owns the Olive Garden and Red Lobster, is already experimenting with dropping the added gratuity, instead including on the receipt three suggested tip amounts for the customer.
That’s a key difference for the IRS, which is classifying automatic gratuities as service charges primarily because they are non-voluntary. Suggested tips, on the other hand, don’t count as service charges since the customer is free to choose how much to tip.
This update on automatic gratuities is a clarification of a 2012 IRS ruling on tips which left the tax treatment of automatic gratuities ambiguous. Despite the IRS’s new guidelines, companies could still run into confusion over how to treat automatic gratuities under the new rules and whether discontinuing the practice would benefit their business. Weigh all your options and speak to your financial advisors so that you’re prepared when the change rolls out in January.
Does your business apply automatic gratuities? Are you considering discontinuing the practice? Contact Darrin Friedrich at firstname.lastname@example.org or Martin Tanenbaum at email@example.com to find out how this new tax ruling affects your business.