Wednesday, October 2, 2013

Why Is The IRS Looking At Restaurant Tips (Again)?



I recently visited one of our clients. He owns a restaurant/bar. That is a tough business under the best of circumstances.  It is a business where almost all your profit comes from paying attention to the nickels and dimes.

Is there anything new out there, he asked?

We talked about the IRS’ recent interest in employee tips and gratuities. What is the difference?
  • A tip is an amount determined by the patron
  • A service charge is an amount agreed upon by the restaurant and patron


The IRS has long defined a tip as:
  1. Paid free from compulsion
  2. Determinable by the customer
  3. Not dictated by the restaurant/employer
  4. The recipient of which is identified by the customer
You may know that restaurant employees are paid a lower minimum wage, as a substantial part of their income is expected to come from tips. The employees are supposed to report their tips to the restaurant, which in turn withholds the employee’s share of the taxes. The restaurant also pays employer FICA on the base wages and tips.

The IRS has long believed that there exists substantial noncompliance with tip reporting by restaurant employees, and it has rolled out a number of “programs” over the years with the intent of increasing compliance. I have been through several of these, and my conclusion is that the IRS just wants money, even if it takes a work of fiction to get there. For example, if the IRS feels that the cash tip rate is too low, they will simply propose a higher rate, and call upon the restaurant (which then means me) to prove otherwise. Failure to do so means the restaurant is writing a tidy check for those actual taxes on proposed tips.

It is unfortunately too common that a server will be under-tipped if he/she is serving a large party. As a defense mechanism, many restaurants have imposed a service charge policy (also known as an auto gratuity or “auto-grat”) on that table or tables. The policy has worked fine for years.

But not for the IRS. They have recently clarified that they don’t believe auto-grats count as a tips, as the customer does not have the option of changing the amount or directing who is to receive it. I have to admit, the IRS has a point. However, are they making things worse by pressing the point? Let’s go through a few issues:

  • The auto-grat will be on the server’s paycheck, rather than cashed out at the end of the shift. This is not a big deal in the scheme of things – except perhaps to the server.
  • Restaurants are allowed to claim a tax credit for employer FICA paid on tips in excess of the amount necessary to get a server to minimum wage.
a.     Reduce the amount considered to be tips and you reduce the credit available to the restaurant.
b.     Meaning more tax to the restaurant.
  • An auto-grat is considered revenue to the restaurant. Tips are not. States with a gross revenue tax – such as Ohio with its CAT – will now tax those auto-grats.
a.     Meaning more tax to the restaurant.
  • Following on the same vein as (3), the customer will pay more sales tax, as the auto-grat is included in sales.
a.     Meaning more tax to the customer.
  • How does one (I don’t know: say my accounting firm) figure out what rate of pay to use if the employee works overtime?
a.     Remember, service charges are resetting the base rate of pay.
b.     What if they server works tips and auto-grat tables over the course of one shift? Do they have one rate of pay or two? How would you even calculate this?
  • Let’s throw a little SALT (State And Local Tax) into the mix: some states do not follow the federal definitions. For example, New York will consider auto-grats to be considered tips if they are separately stated on the receipt or invoice. New Jersey and Connecticut follow this line also.
a.     The good thing is that auto-grats will not be subject to New York sales tax.
b.     The bad thing is the accounting required to figure this out.

How long do you think it will be before the attorneys eviscerate some restaurant chain for violations of FLSA and overtime regulations? Remember, a service charge can change a server’s base pay, something a tip cannot do. On the other hand, the odds of overtime under the current economy are pretty low.

What about discrimination? How long before someone sues for being scheduled insufficient/excessive service -charge/non-service-charge shifts?

You know what I would do? I would do away with service charges altogether. I am not bringing that tiger to the party. Tips only at my restaurant.

Is it good for the servers? Since when does any of this care whether it is good for the employee?

It is about one thing: more money to the IRS. There may have been a time when I would have been sympathetic to the government’s position, but in this day of credit and debit cards, I am cynical about how much “unreported” income there is left to squeeze out of this turnip. I am also concerned that some restaurants may impose a service charge and then keep a portion of it for themselves rather than pass it along in full to the servers and others.  I am unhumored by the IRS, but I would be beyond unhumored by a restaurant that did that to its employees. 

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