Last month the IRS took a major step designed to eliminate the use of auto grats. i.e., gratuities typically added to a bill by a restaurant. Back on June 25, 2012 the IRS issued Rev. Rul. 2012-18 that appeared to say certain gratuities must be treated as service charges and not tips. A concerned restaurant industry asked the IRS for clarification. The IRS issued clarification in Topic 761 Tips on August 29, 2013.

The IRS said in August that:

• Charges added to a bill the customer must pay are not tips but are service charges
• Examples include gratuities added for large parties, corkage fees, room service and delivery charges
• When these auto-gratuities are paid to an employee they are not tips but non-tip wages

In Georgia restaurant operators are already fighting the GA Department of Revenue over auto grats. The DOR is aggressively auditing restaurants and demanding sales taxes on any auto grats they find.

Here is what the IRS’s decision means:

• A tip is not a tip if it is mandatory. It is a service charge
• Service charges belong to the operator, not to tipped employees. These charges should be recorded as income on the restaurant’s P&L (profit and loss statement)
• Auto-grats/service charges paid to employees are non-tip wages. Here’s the kicker; non-tip wages do not qualify for the FICA tip credit

Based on the IRS’s guidance here’s how mandatory tips must to be treated beginning January 1, 2014:

• Mandatory tips must be accounted for separately in the POS (point of sale) system
• Mandatory tips or service charges must be recorded as income on the restaurant’s P&L
• If paid to servers, these tips must be classed as non-tip wages. Not as tips!
• The restaurant cannot take the FICA tip credit for non-tip wages
• The restaurant must file and pay sales taxes on mandatory tips

Why is this a big deal to restaurateurs?

1. Operators will have to reprogram their POS systems to separately track auto grats/service charges. State sales taxes must be collected and paid accordingly
2. Auto grats paid to servers must be run through payroll as regular wages subject to payroll taxes and withholding
3. Non-tip wages do not qualify for the FICA tip credit – the most important tax credit the industry has ever had

Large, national casual-dining companies are deeply concerned about this IRS ruling. Each year these companies claim millions of dollars in FICA tip credits on their annual income tax returns. To avoid the loss of tax credits these companies are experimenting with new ways to collect tips on large parties. One alternative is offer the guest a choice of various tip %s, say, 15%, 18% and 20%.

Due to hostility from the IRS and state taxing authorities, it is clear the days of mandatory tips are rapidly drawing to a close.