Is It A Tip or A Service Charge? The IRS Wants To Know!

In several recent announcements, the IRS has made clear that service charges should be treated as wages and not tips.  A tip examination should redistribute any service charges that were characterized as tips and treat them as wages by adjusting Form 941 with employment tax report Forms 4666 and 4668, and should not include service charges in any calculation resulting in an hourly tip rate.  The deadline for employers to comply with IRS guidance on these matters has been extended to January 1, 2014 so that businesses will have ample time to change their practices.

To be considered a tip by the IRS, four conditions must exist:

  1. the payment must be freely made without compulsion
  2. a customer must have the unrestricted right to determine the amount
  3. the payment should not be the subject of negotiation/dictated by employer policy
  4. a customer generally has the right to determine who receives the payment A tip left on a table or included by a customer on the receipt tip line would be considered by the IRS as a tip because it meets these four conditions.

A fixed charge added to a bill by a restaurant is a service charge — not a tip — as it does not meet the four conditions above.  A bottle service charge, or room service charge, luggage service charge, pizza delivery charge, or other retail deliver charge is are not considered to be a tip.  Service charges should be treated as wages, and are therefore subject to the appropriate withholding taxes.  Therefore, they are not eligible for the tax code Section 45B general business tax credit that certain food or beverage employers can claim for social security and Medicare taxes paid or incurred by the employer on certain employees’ tips.

IRS has also issued guidance on employer and employee FICA obligations.  Tips received by an employee are considered paid by the employer for purposes of the employer’s and employee’s share of FICA taxes when a written statement that includes the amount of the employee’s tip income is provided to the employer by the 10th day of the following month.  If the employee fails to furnish a statement, remuneration is deemed to be paid on the date that notice and demand for the taxes is made to the employer by IRS.  An employee’s unreported tips are deemed to be paid to the employee when the employee actually receives them.

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