When is a tip not a tip? It's not a simple question. Say, for example, a restaurant menu says that a mandatory gratuity of 18% will be charged on all parties of 6 or more. Is that money a "tip"? According to the IRS, a mandatory gratuity that is automatically added to a customer's bill is not a "tip". The IRS ruling which established this point was issued in June 2012, but its effective date was delayed until January 1, 2014.

            The IRS and wage-hour authorities have long drawn a sharp legal distinction between a "tip" (which a voluntary payment left by a guest to reward a service provider) and a mandatory service charge, which is a sum that the establishment adds to a guest's bill pursuant to a predetermined contractual arrangement. According to the IRS and the wage-hour authorities, the difference between the two ultimately lies in whether the guest is obligated to pay the sum or whether payment is completely voluntary. This has important implications for tax and wage-hour compliance.

            Why is this important?  If the money is a service charge, the payment is deemed gross receipts of the house and the house may choose to keep it all or distribute some of it to employees. Since the payment of the service charge monies to employees is optional, then once the funds are paid they are deemed to be W-2 "wages" and tax withholdings must be made on the sum. This same rule applies to any other payments which an employee receives over and above the employee's regular wages.  

           In the restaurant example above, the new IRS ruling clarifies that a mandatory gratuity is just another form of a mandatory service charge commonly added to a customer's bill, like those charges added for banquet events or room service orders in a hotel. Thus, any portion of a mandatory tip/service charge that is paid to employees is taxable income and withholdings must be made as well. 

            According to the IRS, for the charge to be treated as a non-wage "tip" (and thus be non-taxable), the IRS will require all four of the following factors to be established:

• The payment is voluntary
• The customer has the absolute right to determine the amount
• The payment is not negotiated or dictated by the employer
• The customer generally has the right to determine who receives the payment

            The IRS provides two examples to illustrate if the charge will be treated as a tip or a service charge/wage. If the restaurant's menu states that an 18 % tip will be added to the customer's bill for large parties, the charge is not a tip and will be treated as wages for tax withholding. On the other hand, if the restaurant merely includes the amount of a suggested tip on the bottom of the bill, such as 15 %, 18 % or 20 %, but the gratuity line is left blank for the customer to fill in whatever amount the customer wants to leave, the charge will be considered a tip.

            Whether the charge is a tip or a service charge also has an important effect on wage-hour law compliance when calculating overtime pay. Under California and federal wage-hour law, a service charge paid to the employees is also considered a form of W-2 wages and the payment must be included when determining the employee's "regular rate" for purposes of calculating overtime pay. In contrast, a "tip" does not have to be included in the employee's regular rate for overtime calculation purposes.

            Further, tips belong to the employees to whom they are given, and employers (or supervisors) are prohibited from taking or sharing in any portion of tips. In contrast, mandatory service charges belong to the employer, meaning that the house can choose to keep it all if it wants to. Therefore, only the portion of the service charge monies which is actually distributed to employees is treated as W-2 wages for overtime calculation purposes.  

            This gets even trickier if the payment is described as a "mandatory gratuity" to the customer. The most prudent course is to distribute any payment designated as a "gratuity" to the employees.

            To comply with the new IRS rules, and to avoid having to pay overtime on the tip, employers should be very clear with customers that the amount of the tip is discretionary. While employers can suggest the tip amount, it should not be automatically added to the bill or included in the gratuity box.

            Employers should consult with their labor counsel and tax advisors to be sure they are complying with the new IRS rules and overtime requirements.