The IRS recently issued guidance on the difference between a tip and a service charge.
The distinction is important because service charges are considered revenue of the establishment. To the extent that the service charges are, in turn, paid to the employees, that amount is compensation, subject to all payroll taxes and withholdings.
The employer’s calling the payment a “tip” is not conclusive. Customer payments are considered tips when all of the following requirements are met:
1. The amount must not be determined by the employer.
2. The customer has full discretion to determine the amount of the payment.
3. The payment must be freely made.
4. The customer can generally decide who receives the payment.
The IRS believes that the absence of any of these components suggests that the payment is a service charge instead of a tip.
This is an important clarification because the amount of compensation paid to employees affects not only the computation of payroll and withholding taxes due but also the calculation of other benefits based on compensation. In addition, service charges are not eligible for the employer tip credit.
In Announcement 2012-25, the IRS advises all businesses to make any needed system or procedure changes to fully conform to these rules by Jan. 1, 2013.