IRS Alters Tax Treatment of Automatic Gratuities
The Internal Revenue Service (IRS) has provided administrative guidelines to its examiners concerning Rev. Rul. 2012-18, published in the 2012-26 Internal Revenue Bulletin, that note when performing a tip examination (aka audit), IRS examiners must ensure that service fees or charges are properly characterized as wages (where FICA rules apply) and not tips.
The IRS notes that for an employer to claim a payment as a tip, it must meet the following criteria:
- The payment must be made free from compulsion;
- The customer must have the unrestricted right to determine the amount;
- The payment should not be the subject of negotiation or dictated by employer policy; and
- Generally, the customer has the right to determine who receives the payment.
If any of those factors are missing, it raises doubt as to whether a payment is a tip and indicates that the payment may be a service charge.
Rev. Rul. 2012-18 includes an example to make the distinction between a service charge and a tip: If an employer has a policy of automatically adding an 18% charge to the bill of parties of six or more, that would be considered a service charge, but a bill with sample calculations of different tip amounts (e.g., 15%, 18%, or 20%), where the actual tip line is left blank, is a tip.
Although the guidelines are not a rule and the IRS is not required to adopt suggestions, comments were submitted in response to the guidelines that recommended the IRS:
- Should not retroactively require additional taxes, interest and penalties based on this new guidance and any changes should be applied prospectively only;
- Provide employers until at least January 1, 2014 to comply;
- Provide smaller businesses additional time to comply;
- Take specific circumstances into consideration in determining if adjustments and penalties should be applied;
- Clarify standards to characterize tip vs. service charge income to resolve questions not addressed in guidance. and
- Consider industry input before any changes are made to existing agreements and until additional guidance is issued concerning the characterization of tip and service charge income.
It is recommended that hoteliers consult with their tax advisor or attorney to ensure their policies are in compliance with the IRS guidance and practices.