Executive Summary: Beginning on January 1, 2014, "mandatory gratuities" or service charges are no longer considered "tips" by the Internal Revenue Service, and thus are not excludable from FICA withholding. This change may make it less attractive for hospitality employers to use mandatory gratuities for large groups or banquets. It may also create more confusion in an already complex area of the law.
Since 1994, employers have been able to characterize mandatory service fees as "tips" for tax purposes, and thus avoid paying FICA tax on those amounts. This had an obvious advantage for both employers and employees, and led to widespread use of this method of payment. In 2012, however, the IRS released Revenue Ruling 2012-18, which states that it will begin to consider such payments to be "wages" rather than "tips," and thus subject to normal withholding rules. The IRS applied its traditional test for determining whether a payment was a "tip," which includes looking at whether the customer decides the amount of the payment, who receives the payment, etc. In this case, because the payments are mandatory, the IRS will consider them to be wages. For more information on the Revenue Ruling, please see our July 3, 2012 Legal Alert, New Authority Concerning Tax Treatment of Tips.
The IRS's ruling that mandatory service charges are wages brings its position in line with the U.S. Department of Labor's long-standing position that mandatory service charges are wages, not tips, under the Fair Labor Standards Act ("FLSA"). Several state agencies have adopted the DOL's position or have taken a more restrictive stance on the issue.
In July of 2013, the DOL issued a fact sheet on tip credits and clearly stated that under the FLSA, mandatory gratuities are also considered to be "wages," not tips paid by customers. See http://www.dol.gov/whd/regs/compliance/whdfs15.pdf. According to the DOL, even though these mandatory gratuities would need to be considered wages, employers may still use the charges to satisfy prerequisites that employers must meet to claim a "tip credit" against the minimum wage. The tip credit allows employers to pay a reduced federal minimum wage of $2.13 to tipped employees who earn at least $30 dollars in tips a month. For example, in the case of tipped employees for whom a tip credit is taken, an employer could use money derived from mandatory service charges to pay the $2.13 cash wage required by the FLSA, or could use service charges to satisfy the entire minimum wage of $7.25 per hour, thus eliminating the need to apply a tip credit at all. Additionally, because mandatory service charges are not tips, they are not subject to the restrictions against tip sharing and tip pooling that apply to tips. Note that state wage and hour laws may have different or more restrictive requirements regarding the use of mandatory service charges and the compensation of tipped employees, thus employers should ensure they are in compliance with any applicable state laws.
Finally, when wages derived from mandatory service charges constitute more than half of an employee's compensation, he or she may, assuming other factors are present, be exempt from the FLSA's overtime provisions under the commission-sales exemption set forth in § 207(i) of the FLSA. Application of the 7(i) exemption is complex, and counsel should be consulted prior to its use.
Employers' Bottom Line: Payment of wages in the hospitality industry is complicated, and many employers are not in compliance because of simple misunderstandings of the law. For help with specific payment plans, including tip credits or the 7(i) exemption, or for more information on this topic, please contact David Prather, a partner in our Memphis, Tennessee office, 901-291-1529 or email@example.com, or Salvador Simao, a partner in our Berkeley Heights, New Jersey office, 973-646-7302 or firstname.lastname@example.org, co-chairs of FordHarrison's Wage Hour practice group, both of whom previously held positions with the DOL. You may also contact the FordHarrison attorney with whom you usually work.