IRS Update on Service Charges vs. Tips

At the beginning of 2014, the IRS began enforcing the rule that service charges are considered part of an employee’s wage – not a tip – and are therefore subject to withholding and reporting requirements.

Distinguishing between service charges and tips can be a tricky process. To classify as a tip, you must be able to prove payment from the customer was:
  • Voluntary
  • Determined solely by the customer
  • Not dictated by restaurant policy
The customer also must generally have the right to determine who receives the payment. And, when it comes to a predetermined service charge, the customer’s ability to change the amount is not enough to classify it as a tip.

The enforcement of this new definition, which originally came out in June 2012, was delayed until this year to give business owners time to comply. At a National Restaurant Association conference in June, two IRS officials discussed what the organization is doing in regards to the issue of service charges vs. tips, including:
  • Communicating updates to the original Rev. Rul. 2012-18 (clarifying that tips must be voluntary
  • Responding to questions and developing FAQs, which will soon be posted to the IRS website
  • Working with state authorities regarding sales tax and other areas
  • Developing an audit technique guide
They also discussed the top two future audit issues when it comes to service charges vs. tips:
  • Substance vs. form
  • IRC section 45B credit computation
The officials indicated that the IRS employment tax division plans on securing additional resources to work on tip issues. In addition to restaurants, they would like to focus on tips in other industries such as hair, transportation, and hotels.

It is likely that the IRS will be looking at the classification of service charge vs. tips. Restaurants need to review their specific fact pattern and ensure voluntary payments received are properly classified as tips to minimize employment taxes and maximize the IRC section 45B credit.