• Tax Considerations Related to Tips vs. Service Charges

Tax Considerations Related to Tips vs. Service Charges

The recent IRS rules that redefined tips and service charges are still generating a great deal of questions from restaurants. Understanding how to implement these new rules when it comes to catering and delivery can be challenging.

As we’ve discussed in a prior blog post, the ruling helps determine the classification differences between tips and service charges. Becoming familiar with the IRS definitions of both tips and service charges are important as these classifications impact whether or not a restaurant is subject to withholding and reporting requirements.

As you may recall, the IRS cites the following four conditions that must exist in order for a payment to be considered a tip:
  1. The payment must be made voluntarily, free from compulsion
  2. The customer must be free to determine the amount of the payment
  3. The payment is not negotiable, nor can the employer dictate the amount
  4. The customer should generally have the right to decide who receives the payment
Prearranged service charges such as large party automatic gratuities, banquet event fees, or bottle service charges are not considered by the IRS to be tips.

What is the proper classification of gratuities on catering contracts?

The answer depends on the facts and circumstances of each arrangement. For example, if a prearranged fixed amount tip on a banquet contract is dictated by the restaurant and is not voluntary, it would not be considered a tip. If, however, the contract language allowed the customer to meet the four conditions mentioned above, it is possible to have a tip classification for a banquet or catering event. If no tip is required, but sample computations are provided for the convenience of the customer, the IRS may consider it to be a tip, since the situation is similar to an example outlined in an IRS publication.

What are the considerations around tip versus service charge classifications for delivery?

Some restaurants don’t charge a delivery fee, but rather leave it up to the customer to tip the driver or person that delivers the food. A required delivery fee will not meet the four conditions above and will be treated as a service charge rather than a tip. However, when the customer voluntarily gives the delivery person a payment, this may be classified as a tip. Many customers pay for delivered food by charge card and often add a tip to the bill. Generally, this means the employer can take advantage of the FICA tip credit, which has the potential to add up quickly. Fast food restaurants, in particular, may not have previously considered this credit. It may be worthwhile for you to review your delivery policies to ensure you are realizing potential tax savings.

Contact your BDO Restaurant practice professional with additional questions about tips vs. service charges. We’re happy to help.