With the new year came new Internal Revenue Service rules on automatic gratuities that may change how restaurants handle tips for large parties.

The IRS’ revised Ruling 2012-18 draws a sharper distinction between tips and service charges. Many restaurants for years have added fixed gratuities to parties of five or more, but the new IRS rules on what constitutes a tip require restaurant owners to treat them as service charges, which are a part of wages.

Joseph Henchman, vice president of legal and state projects at Washington, D.C.-based think tank Tax Foundation, said that “in order for it to be a tip, it has to be voluntary; it has to be entirely set by the customer; it has to be the subject of something the customer comes up and not dictated by a policy; and the customer has to decided who gets the tip.”


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Henchman noted that getting around the automatic-gratuity rule would be difficult for any restaurant operator. “It’s going to be hard to avoid all four of those things,” he said in an interview.

Other critics have said the change will complicate payroll accounting. While both wages and tips are taxable, tips are often reported and cashed out that day while wages must go through the payroll process.

“It’s certainly a change in how things have been done. It’s the tail end of a lot of changes that have happened in reporting tips over the years,” said Henchman. “The IRS needs to hear how their rule changes are affecting real business owners. I certainly hope anyone with stories pro or con on these changes will make them heard.”

Darden Restaurant Inc.’s Olive Garden and Red Lobster brands have already reportedly tested getting rid of the automatic gratuity. Henchman also said he knows of one restaurant company that is putting “suggested amounts” for tips on larger-party receipts.

Henchman, who also serves as The Tax Foundation’s vice president of operations, discussed the rule change with Nation’s Restaurant News.

How will the rule change impact restaurants?

Right now a lot of restaurants will automatically put a gratuity on for large parties in order to make sure their staffs are willing to work those large groups without the fear of being under-tipped. Unfortunately, the administrative change that the IRS is going to require with this new revenue ruling makes [automatic gratuities] a lot less appealing for restaurant owners and wait staff. We’ll probably see those go away. I would imagine it would become harder to find wait staff to work large parties.

What operators can do

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What led to this rule change?

The IRS, for a long time, has been trying to crack down on the under-reporting of tip income. Back in the day, of course, if you were a waiter or waitress, you wanted to make sure you got your tips in cash and you didn’t report them and just pocketed them. That’s all kind of gone now with credit cards; there is a lot of better reporting and better tracking. The IRS has had more stringent reporting requirements. People need to report their tips frequently, and taxes need to be withheld from them. This is just the next step for the IRS in the effort of theirs.

I would argue that they have already kind of solved the problem, and now they are just looking to keep doing things. I don’t think this will flesh out any under-reported tip income that their previous efforts haven’t already achieved.

What effect will the change have on restaurant operations?

The big change, of course, is that any service charge of this type has to go through the payroll process. You can’t cash out your servers that day. Instead, it has to go into payroll, and taxes need to be withheld at that time and you need to sort it out with hourly wages. That can all get pretty complicated.

It’s going to be a headache but maybe not that much additional headache, although it will be a problem to the servers who are used to taking their tips home the day that they earn them rather than maybe two weeks later when it goes through payroll.

If you are a large restaurant company, you probably already have this infrastructure. For smaller restaurants, maybe you don’t have this infrastructure and maybe it’s a lot hard to do this kind of thing.

What advice do you have for restaurant operators regarding this policy change?

Probably the best thing is to talk with your wait staff. Let them know that this change is taking effect and that it’s coming from the IRS and not from you. And get their input on what the best solution might be going forward.

What are those solutions?

The choices are: how important is it that they take their tips home that night, which is usually pretty important for wait staff, vs. having to go through the payroll process and divvy it out that way. Weigh that against being under-tipped for large parties, which is a big problem.

What are some ways restaurants can urge patrons to add a gratuity?

There are ways to gently encourage patrons: don’t forget to tip your wait staff. As the IRS says, you can’t require it now, as it’s no longer a tip — it’s a service charge.

Contact Ron Ruggless at ronald.ruggless@penton.com.
Follow him on Twitter: @RonRuggless