By: Kara M. Maciel

Many restaurants include automatic gratuities on guests’ checks with large parties to ensure servers get fair tips. This method allows the restaurant to calculate an automatic gratuity or tip into the total bill, but it takes away the customer’s discretion in choosing whether and/or how much to tip the server. As a result of this removal of a customer’s voluntary act, the IRS has decided that it will separately tax automatic gratuities.

In 2012, the IRS issued a ruling to clarify earlier tax guidance on tips, particularly automatic gratuities, but because restaurants persuaded the IRS to hold off for a year, the IRS did not immediately enforce that ruling. As of January 2014, however, the IRS will begin classifying automatic gratuities as service charges, taxed like regular wages. 

This change is expected to be problematic for restaurants because the new treatment of automatic gratuities will complicate payroll accounting. Each restaurant will be required to factor any automatic gratuities into the hourly wage of the employee, meaning the employee’s regular rate of pay could vary from day to day, thus adding a potential complication to overtime payments. Furthermore, because restaurants pay Social Security and Medicaid taxes on the amount its employees claim in tips, restaurants are eligible for an income-tax credit for some or all of these payments. Classifying automatic gratuities as service charges, however, would lower that possible income-tax credit. Finally, it will produce more paperwork and add to the already rising costs restaurants will incur due to the Affordable Care Act. 

Restaurants considering eliminating the use of automatic gratuities are unlikely to face much backlash from employees, as the IRS’s ruling could disadvantage them as well. For example, employees could come under greater scrutiny in reporting their tips as a result of this ruling. Furthermore, these tips would be treated as wages, meaning upfront withholding of federal taxes and delayed access to tip earnings until payday. For those waiters and waitresses used to coming home with money in their pockets each workday, such a delay could prove a serious financial hardship.

Some restaurants have begun moving toward the use of suggested tips on a customer’s bill instead of charging an automatic gratuity in light of this change. For example, Darden Restaurants Inc., has begun implementing a new system in some of its restaurants in which three suggested tip amounts, 15%, 18% and 20%, appear on all customer bills. This system allows the customer to exercise discretion in choosing whether and how much to tip. In its ruling, the IRS suggested that such a practice would not be subject to federal withholdings because the decision to leave a tip is still voluntary. Therefore, this practice presents a viable alternative to automatic gratuities as it provides some protection for employees without incurring increased tax penalties.

Other restaurants, including several in New York City, have begun doing away with tips all together. These restaurants have replaced the practice of tipping with either a surcharge or food prices that include the cost of service. They can then afford to pay their servers a higher wage per hour in lieu of receiving tips. This is another way for restaurants to ensure employees receive a sufficient wage, while simultaneously removing the regulatory burdens that a tip-system may impose.