The IRS will begin enforcing a new rule concerning the taxation of automatic gratuities on January 1, 2014. Specifically, employers must start treating automatic gratuities – that is, charges that are compulsory to customers – as service charges, rather than gratuities for tax purposes.

The IRS has provided four factors that govern whether the payment should actually be considered a service charge, rather than a gratuity:

1. The payment must be made free from compulsion;
2. The customer must have an unrestricted right to determine the amount of the payment;
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 received the payment.

If all of these factors are not met, a question arises of whether the payment is a gratuity. As such, the IRS has explicitly stated that an automatic gratuity (e.g., an 18% gratuity is automatically added for parties over a certain size) is not a gratuity, as it does not give the customer the unrestricted right to determine the amount of the payment and does not allow the customer to make the payment free of compulsion. Because an automatic gratuity fails to meet the above-listed test, it must be treated as a service charge.

In practice, the change from treating automatic gratuities as gratuities to as service charges will significantly impact payroll accounting for employers. Employers who continue to charge automatic gratuities to customers will face several changes:

• Employers will have to factor any automatic gratuities into the hourly wages of the employees. This means that the employee’s regular rate of pay may vary from day-to-day, which can greatly complicate overtime payments.
• Employers will not be able to use automatic gratuities as a tip credit to meet the minimum wage requirements under the FLSA or state law. This means that employers who are paying the lower minimum wages allowed under state and federal law ($2.63/hour in Massachusetts) will have to ensure that an employee’s hourly wages plus tips, excluding automatic gratuities, are sufficient to meet the minimum wage requirement ($8.00/hour in Massachusetts).
• Employers will have to pay Social Security and Medicaid taxes on automatic gratuities as wages. Employers currently pay Social Security and Medicaid taxes on automatic gratuities as tips, rather than wages, which means that employers receive tax credits for some or all of these payments. Therefore, this change will lower employers’ potential tax credits.
• Employers will have to treat automatic gratuities as wages for the purposes of upfront withholding of federal taxes, which also means, as a practical matter, that employees will not receive access to their automatic gratuities until the employer’s payday.

Because of the widespread effects of this new IRS rule, many employers are choosing to avoid automatic gratuities by either including “suggested tip amounts” that leaves the customer with discretion as to what percentage, if any, to tip the employee or by eliminating gratuities altogether by using surcharges or increasing food prices and paying servers a higher hourly wage.

For those employers who plan to continue to use automatic gratuities after January 1, 2014, the preparation should start for the payroll and tax consequences of this change.