IRS Revenue Ruling 2012-18 is now in effect for all restaurant operations that attaches a service charge to their guests’ checks. This has actually always been the proper way to handle these types of transactions but the ruling is a warning of the IRS’ intention to now audit and enforce this procedure.

Most restaurants have correctly associated this event with sales tax but probably never went any further in researching why there was sales tax applied to the transaction. The difference lies in the definition of a tip and a service charge.

A tip is an optional payment made at the discretion of the guest. A service charge, or auto-gratuity, is an additional mandatory charge placed on a check by the restaurant establishment. The origins of the service charge may not have a stellar history in the restaurant business. The practice is usually in defense of the server and based upon some vague research on the type of guests that don’t tip well, whether it be an ethnic group or foreign travelers or simply large parties. The research on tipping does not lead to any empirical evidence that any of those situations actually cause a guest to tip less. Usually what makes a guest tip less is dissatisfaction with their experience in the restaurant.

The proper application of this new ruling requires the restaurant operator to assign service charge income to the employee as wages earned, much like an additional bonus, for that payroll period. This, in turn, will change the employee’s hourly effective rate (also known as the regular rate). For example, if you have an employee who worked thirty (30) hours during a pay period at eight dollars ($8.00) an hour, their pay would equal to two hundred and forty dollars ($240.00) before taxes. Add two hundred dollars ($200.00) in service charge income to those wages and the effective rate for the employee during that pay period equals fourteen dollars and sixty-seven cents ($14.67). This calculation is based on the regular wages due ($240) plus the service charge income ($200), divided by the total hours for the payroll period (30). It is this effective rate that overtime during that pay period would have to be calculated on.

The additional expense in payroll taxes and overtime is easy to see, but the hidden cost is the amount of administrative time both management and payroll staff have to spend in order to calculate and change an employee’s effective rate on a payroll by payroll period. For example, in California it is required to accurately list the effective rate on the employee wage statements each pay period – so it’s only a matter of time before a mistake is made and an employee has a claim for non-compliance with Labor Code sections 226 and 2810.5.

What’s more difficult, I think, is explaining this to your server group. Why…once again, they are losing an opportunity to control their own recording of income. I think one of the strategies has to be that we are all in it together and that half the payroll taxes on this activity are being paid by the restaurant. Or, have a different conversation and get rid of the service charge altogether and let them work for those tips on large parties; it could save them taxes in the long run, and will certainly minimize the restaurant’s exposure for not properly calculating the effective rate.

There are restaurants experimenting with a flat service charge charged to every guest and tipping is not allowed. The idea behind this is that tipping doesn’t really motivate servers as much as doing a good job and being appreciated by their managers/owners. It goes a long way in leveling out the disparity between tipped and non-tipped employees in a restaurant – hopefully creating a more “team” culture that benefits the guest experience. Some of these restaurants are passing the service charge to the employees as part of payroll (as described above) and some are paying an accelerated hourly rate to employees. You may question this theory based on what we think we know about restaurant employees, but I do think that knowing what you are going to make when you go to work might help stabilize your workforce and help you identify truly good servers who deserve a higher hourly rate than others. Depending on what city/county or state you are operating in, you need to be sure to be compliant on how guests are notified of potential service charges. Some cities actually have a limit allowed by law for service charges.

One important calculation here is the loss of F.I.C.A. tip credits to the operator. This should be part of your calculation as it can be a considerable loss for those restaurant owners that can use the tax benefits.

There are lots to consider as we jump into 2014. If you have questions or comments please feel free to contact me, I would love to know how you plan to approach these issues.

Author: Jean Hagan, Principal – Restaurant Operations Practice Leader