IRS Crackdown on Automatic Gratuities Takes Effect January 1

December 30, 2013

“Automatic gratuities” added onto the restaurant bills of large parties will be treated as wages and not tips starting January 1, 2014, as a suspended IRS ruling finally takes effect. Many restaurants add these charges to groups of 5 or 6 or 8 or more to prevent their servers from being undertipped when handling large parties.

Under the IRS ruling, Rev. Ruling 2012-18, a sharper distinction is drawn between tips and service charges. Both are taxable but tips are reported and cashed out that day. Under the new rules, to be a tip:

(1) the payment must be made free from compulsion;

(2) the customer must have the unrestricted right to determine the amount;

(3) the payment should not be the subject of negotiation or dictated by employer policy; and

(4) generally, the customer has the right to determine who receives the payment.

Automatic gratuities don’t meet these criteria, so they would be classified as service charges. Employers would have to cycle these charges through their payroll system to distribute to servers, delaying payment by up to two weeks, and factor them into hourly wage rates.

The likely result is that restaurants will discontinue automatic gratuities for large parties, to avoid additional compliance costs and to allow employees to take their tips home on the day they get them. Getting servers to work large parties will probably be harder.

The IRS views this as the latest step in their effort to crack down on underreported tip income although previous enforcement efforts (employee and employer reporting requirements and high-profile investigations) and the shift from cash to credit for most payments has ended this evasion for the most part. To the IRS, it’s just a clarification “in the best interest of tax administration.” But one that will make life a little bit harder for restaurants and their waitstaff.

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