Automatic gratuities (typically 18%) take away the customer’s discretion in choosing whether and/or how much to tip the server.  The IRS may classify these as service charges, not tips, and these revenues will be taxed as wages (not tips).  As a result of this removal of a customer’s voluntary act, the Internal Revenue Service has decided that it will tax employers (not employees) on automatic gratuities separately from ordinary tips.

Tips Versus Service Charges

Under the Fair Labor Standards Act, employees may receive tips for services provided to customers.

For a payment to constitute a tip, the customer must be able to decide whether to leave the tip, the amount of the tip and the recipient of the tip.  A tip provided voluntarily by a customer belongs to the tipped employee alone, and the employer cannot require that the employee divulge his tips to the employer.

Service charges are compulsory charges for service.  Service charges differ from tips in three significant ways:

(1)  there is no customer discretion as to whether to pay the charge, how much to pay or who receives the payment;

(2)  the payment belongs to the employer; and

(3)  these payments are not counted as tips even if distributed to service employees.

Now is a good time to review your policy on automatic gratuities and make any adjustments to avoid negative tax consequences for your business.