You may think that the 20% tip you leave when you are out for a romantic dinner for two is the same as the 18% service charge the restaurant adds to your bill when you have a celebratory dinner for eight, but there’s a difference. A new IRS ruling shines a light on this sometimes confusing area.
IRS Ruling 2012-18 provides guidance for employers and employees in a question and answer format on taxes imposed on tips under the Federal Insurance Contributions Act (FICA), including information on the difference between tips and service charges.
Even if it’s described as a “tip,” a payment that constitutes a “service charge” and is distributed to employees is actually part of their “regular rate” for overtime purposes, and is subject to withholding and reporting as wages.
Under existing authority, i.e., Rev Rul 59-252, there’s a test for determining whether a payment made in the course of employment is a tip or not under IRS §3121. If any of the following four factors are absent, there’s a good chance the payment is a service charge, not a tip:
- the payment isn’t compulsory;
- the customer has the unrestricted right to determine the amount;
- the payment isn’t negotiated or dictated by employer policy; and
- the customer generally may determine who receives the payment.
All of these factors are what most of us believe are true of tips. But few have thought much about how they differ from “service charges.” A tip belongs to the employee for whom it is intended; a service charge is the property of the employer, and is reported differently. The employer is entitled to an income tax credit under IRC §45B for FICA taxes paid on tips, but not for service charges. Now businesses and employees are going to have to understand the difference and get it right when it comes to payroll and tax time.
For information on the payment of wages, turn to CEB’s award-winning book California Wage and Hour: Law and Litigation, chap 5. CEB’s Advising California Employers and Employees, chap 5 also covers wage and hour laws.
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