Beginning in 2014, the IRS Mandatory Gratuity Rules came into effect, changing the way businesses like restaurants or other enterprises that charge from their customers' tips or mandatory gratuities (service charges) will pay their employees going forward.
Difference between the tip and the service charge
The ruling distinguishes between the category of tip and that of mandatory gratuity. Extra payments made by customers are deemed to be tips if they are made free of any compulsion and the customer is fully entitled to determine the amount of the payment as well as to decide about who will receive the payment.
Tips are not taxable if they don’t exceed the amount of $20/month. If the employee receives more than $20 a month in cash tips, he or she must report the amount to the employer, and the income received this way will be considered as wage and be taxed accordingly.
Service charges (or mandatory gratuity)
Mandatory service charges are handled differently. They are tips added to the bill by the company that issues the bill, without the customer being allowed to determine the amount charged this way (non-compulsory).
These charges are to be considered non-tip wages, meaning companies that continue to charge mandatory gratuity must set up an income item in their payroll system and include the income into the net payment given to the employee. Service charges are to be taxed as regular wages and will therefore be subject to payroll tax withholding.
You can also check out our comprehensive resource page on Payroll for Restaurants, which explains all of the essential components and considerations along with links to government forms, helpful articles and other resources.
Impacts on payroll and bookkeeping
Both mandatory gratuity and voluntary tipping involve certain payroll and tax-related aspects that must be addressed by company bookkeeping departments and payroll consultants. Even though tips and mandatory service charges are not easy to keep track of, gratuity-based businesses must develop a system to be able to follow these types of income if they and their employees are to comply with the IRS ruling.
Check out our comprehensive employer's guide to payroll taxes - a structured and simple overview of what employers need to know about the taxes that flow through payroll - on both the employer and employee side.