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IRS automatic gratuity ruling set to begin in January 2014

When is a payment regarded as a tip or a service charge?

According to the IRS: (1) the payment must be made free from compulsion; (2) the customer must have the unrestricted right to determine the amount; (3) the payment should not be the subject of negotiation or dictated by employer policy; and (4) generally, the customer has the right to determine who receives the payment.  

Why does it matter whether a payment is a tip versus a service charge?

  • Service charges are considered wages, and, therefore, not eligible for the FICA Tip Credit (The 45B Credit).  For many years, restaurants have benefited from being allowed to apply a general business credit toward a portion of the employer’s social security and Medicare taxes paid on tips in excess of the federal minimum wage as of Jan. 1, 2007 (i.e., $5.15 per hour).
  • In many states, Tips are not included in wages for the purpose of computing workers’ compensation premium.  Service charges are included, thus increasing this insurance expense.
  • When completing Form 8027 (Employer’s Annual Information Return of Tip Income and Allocated Tips), service charges distributed to employees and the respective sale should not be included on the form.
  • Businesses will have to change their reporting systems to comply with this distinction.
  • Employers who pay out a portion of the automatic gratuities or service charges to employees may have to recalculate its employees’ overtime rates.  The ruling considers these payouts to be wages, rather than tips, so that money counts toward the employee’s regular rate of pay and should be factored into the overtime calculation.

Article by PayMaster, Inc., “A Better Way To Pay”. You can contact PayMaster at 888.717.5577 or find them online at