By Linda Erdmann, CPA, Schenck
Laying down extra cash for exceptional service is common practice in the restaurant industry. Many customers want to acknowledge a job well done, but what happens when you automatically add a service charge? Knowing how to manage the differences from a payroll perspective is critical as tips and service charges are taxed differently to your employees.
Employee tips can be defined as follows:
- The payment must be made free from compulsion
- The customer must have the unrestricted right to determine the amount of the tip
- The payments should not be the subject of negotiation or dictated by employer policy
- The customer has the right to decide who receives the payment
Tips must be reported to the employer daily and are subject to all the normal payroll taxes as part of the standard payroll process. Tips are not subject to sales tax.
The definition of service charges, also known as automatic gratuities, does not meet the criteria listed above, and service charges should not be considered tips to the employee. Service charges should be classified as regular wages to the employee and added to their wages.
Consider these service charge examples:
- Groups of six or more are charged a service charge as a percentage of their purchase
- Weddings or parties are charged a service charge fee of either a percentage of their purchase or a specific dollar amount
Service charges are taxed as regular wages and are not listed as tips for W-2s. Wages are subject to all the normal payroll taxes in addition to all garnishments and child support orders.
Pay attention to when you pay service charges to your employee
If you pay service charges to the employee on the date of service, this creates some additional issues for you. As service charges are considered to be wages, the employer’s payroll tax liability starts on the date you pay the service charges (wages) to the employee. Also, note service charges do not qualify for the Business FICA tip tax credit reported on Form 8846.
Service charges are subject to state sales tax.
The above-noted differences in handling employee tips and service charges should be considered when processing payroll. If you would like additional information regarding tips or services charges, please refer to the IRS guidelines or contact your Schenck team representative.
Linda Erdmann, CPA, supervisor, has more than 35 years of experience providing tax consulting and compliance services, as well as guidance with QuickBooks and Sage 50 software. She is a member of Schenck’s Hospitality & Retail Industry team.