18 Aug The Differences Between Tips vs. Service Charges
The IRS has updated a fact sheet that explains the differences between tips and service charges [Fact Sheet 2017-8, 4/25/2017].
Tips are discretionary (optional or extra) payments determined by a customer that employees receive from customers. Tips include: (i) cash tips received directly from customers; (ii) tips from customers who leave a tip through electronic settlement or payment (this includes a credit card, debit card, gift card, or any other electronic payment method); (iii) the value of any noncash tips, such as tickets, or other items of value; and (iv) tip amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip-sharing arrangements.
In general, the following factors characterize a payment as a tip:
- The payment must be made free from compulsion;
- The customer must have the unrestricted right to determine the amount;
- The payment should not be the subject of negotiation or dictated by employer policy; and
- The customer should generally have the right to determine who receives the payment.
Absent these factors, the payment is likely a service charge.
Employees must report to their employer all cash tips received, except for tips from any month that total less than $20. Cash tips include tips received from customers, charged tips (for example, credit and debit card charges) distributed to the employee by his or her employer, and tips received from other employees under any tip-sharing arrangement. Non-cash tips (that is, tips received by an employee in any other medium than cash, such as passes, tickets, or other goods or commodities) from customers are not reported to the employer. All cash tips and non-cash tips are includable in an employee’s gross income and are subject to federal income taxes.
Directly and indirectly tipped employees. Both directly and indirectly tipped employees are required to report tips to their employer. A “directly tipped employee” is any employee who receives tips directly from the customer, including tips that are turned over to a tip pool. Examples include servers, bartenders, and hairstylists.
An “indirectly tipped employee” is an employee that does not normally receive tips directly. Examples include bussers, cooks, and salon shampooers.
Employers are required to retain employee tip reports, withhold employee income taxes and the employee share of Social Security and Medicare taxes from wages paid and reported tips, and then report this information to the IRS. In addition, employers are required to pay the employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees plus reported tip income.
Tips reported to the employer by the employee must be included on Form W-2 in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips). Employers must enter the amount of any uncollected Social Security tax and Medicare tax in Box 12 of Form W-2.
Service Charges Definition
Amounts an employer requires a customer to pay are service charges. This is true even if the employer or employee calls the payment a tip or gratuity. Examples of service charges commonly added to a customer’s check include: (1) large dining party automatic gratuity; (2) banquet event fee; (3) cruise trip package fee; (4) hotel room service charge; and (5) bottle service charge (nightclubs, restaurants).
Generally, service charges are reported as non-tip wages paid to the employee. Some employers keep a portion of the service charges. Only the amounts distributed to employees are non-tip wages.
Reporting service charges
Employers who distribute service charges to employees should treat them the same as regular wages for tax withholding and filing purposes. The new fact sheet notes that distributed service charges must be included in Boxes 1, 3 (Social Security wages), and 5 of Form W-2.
The IRS issued a revenue ruling on this topic in 2012 (see Rev Rul 2012-18, 2012-26 IRB 1032). There are examples in the revenue ruling to support the concepts.
For these and other reasons, many restaurants choose to outsource their payroll so that tips for waiting staff are handled properly. Payroll Partners has been serving restaurants for 21 years, so you can rest assured we have the knowledge and experience to process restaurant payrolls and their tricky earnings correctly. Call us toll free at 1-866-757-8111 or email us at firstname.lastname@example.org to get your restaurant compliant today!
Payroll Partners is committed to helping clients stay informed about payroll and human resource news, developments and current events. This article is intended to provide readers with general information on payroll matters. The article does not constitute, and should not be treated as professional advice regarding the use of any particular payroll practice. All efforts have been made to assure the accuracy of the information. Payroll Partners does not assume responsibility for any individual’s reliance upon the information provided in the article. Readers should independently verify all information before applying it to a particular fact situation, and should independently determine the impact of any particular payroll practice. If you are seeking accounting advice, you are encouraged to consult a certified public accountant.