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Restaurants may want to reconsider the use of automatic gratuities in light of the IRS recent ruling categorizing automatic gratuities as service charges. This ruling took effect on January, 1, 2014.

IRS Revenue Ruling 2012-18 classifies automatic gratuities as service charges which are then considered restaurant income. (Rev. Rul. 2012-18, 2012 26 1.R.B. 1032). If these service charges are distributed to employees, they are considered wages, not tips.

The IRS clarified that an employer’s characterization of a payment as a “tip: is not determinative. Rather, four factors are considered to determine whether a payment is a tip or service charge: (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. The IRS concluded that the absence of any of the four factors creates a doubt about whether a payment is a tip and not a service charge. Automatic gratuities, which fail to meet any of the criteria above, are clearly service charges.

Service charges belong to the restaurant and are considered part of its gross receipts. Additionally, they are considered income to the restaurant. Service charges can be retained exclusively by management or distributed to employees in any amount.

The biggest change brought by this decision is that restaurants that impose automatic gratuities can no longer take the “tip credit” permitted by the Fair Labor Standards Act (FLSA) and the Illinois Minimum Wage Law for employees who customarily and regularly receive tips even if they distribute the gratuities to the employees. Restaurants must pay employees who serve these large parties and banquets at least the applicable minimum wage, because the employees are technically performing non-tipped work. This includes bussers and other front-of-the-house employees who are lawfully involved in tip pools. This obviously raises issues for “dual duty employees” who are performing tipped and non-tipped work when the tasks are performed concurrently.

The likely recommended best practice for restaurants to avoid the effects of the IRS’s rulings is to eliminate automatic gratuities. By permitting large parties and banquets to leave tips subject to their discretion, restaurants avoid having to pay employees higher hourly wages, which also can affect over-time rates. Another suggestion to minimize this risk is to provide suggested tip amounts. Restaurants do not run afoul of the IRS’s ruling by listing suggested tip amounts beneath the signature line on their bills, so long as the actual tip lines are left blank and guests’ tips are voluntary.

Restaurants could also address the IRS’s ruling by continuing to use automatic gratuities but paying employees at lease the applicable minima wage. The effect of the IRS’s ruling is that if a restaurant continues to use automatic gratuities, employees serving these parties are no longer eligible for the tip credit. Restaurants should be especially mindful of employees performing dual duties. When the automatic gratuity applies to some customers but not others in the same setting, servers are performing tipped and non-tipped work. Because the tip credit can be taken only for employees performing tipped work, it is all but impossible to determine these employees’ hourly wage. The best solution is for restaurants to micromanage employees’ schedules to prevent them from simultaneously serving both kinds of patrons.