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Tips vs. Service Charges: Critical Insight from CPA Eats

September 26, 2022
The days of tipping in DC are likely numbered, or at a minimum about to seriously change. Initiative 82  will pass into law and fundamentally transform the compensation model for tens of thousands of workers in the restaurant industry. At Harmony we have concerns about whether this initiative will actually lead to better outcomes for hourly workers because the likely transition from a tipped system to a service charge system is rife with opportunities for money to be transferred from hourly workers to management.
We believe strongly in working with businesses that add value to all stakeholders, so the CPA Eats team stands ready to guide our restaurants through this inevitable transition in a way that best expresses their goals and values.
This month's Lesson From the Line is a primer on the differences between tips and service charges - especially for those who don’t realize that the two compensation systems are vastly different, by law, or need a reminder of all of the nuances that need to be accounted for. It also reminds clients that auto gratuities are actually service charges, legally, and need to be accounted for accordingly. It will be important knowledge in the post-tipped world that is coming to DC.
Matt Hetrick, CPA
President and founder of Harmony Group Inc.
With pending legislation in Washington DC that follows similar patterns in other large cities and states around the county seeking to eliminate the Tip Credit, now is a good time to examine the difference between tips and service charges.  
Setting aside any pending legislation, the last two pandemic years saw an exponential increase in the usage of automatic gratuities or service charges – which we’ll call “mandatory charges.” We lump them together because there is no difference recognized in the law, tax code, or labor guidelines between automatic gratuities and service charges.
Once reserved for large parties, mandatory charges exploded in popularity as carry-out dining (third-party delivery and otherwise) became a large part of restaurants’ pandemic business plans.  The charges were helpful in sustaining a labor force working in challenging times. Mandatory charges were also sometimes introduced with the goal of redistributing income between departments with the intent of evening the pay disparity between FOH and BOH. Similarly, some restaurants introduced a health/wellness charge to subsidize the laudable goal of offering health insurance coverage to employees.
While well intentioned, mandatory charges can create hidden liabilities and pitfalls if not managed correctly.
The most important thing to understand is that mandatory charges (auto-gratuities and service charges) are NOT tips (which pass through directly to the employees), the charges are treated as business revenue subject to taxation. To be treated as a tip, exempt from taxation, the Internal Revenue Service applies a four-part test – all of which must be satisfied:
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 negotiations or dictated by employer policy; and
Generally, the customer has the right to determine who receives the payment.
Most states (and the District of Columbia) follow the Federal guidance, with New York being a notable exception. In a recent court case, the 11th Circuit affirmed these guidelines and ruled even if all the monies collected from these charges were paid to employees and the money was (incorrectly) not declared as revenue that will not convert these charges into tips.
Treating mandatory charges as tips can create liability and added costs for businesses. The chief areas of concern are creating a sales tax liability, disallowing use of the FICA Tip Credit and misclassification of employee compensation.
Many employers who institute these charges view them as a substitute for tips, not as revenue to be taxed, because they pass through all the money directly to the employees. This good-hearted practice can create an unexpected tax bill because employers in the District of Columbia and Virginia are responsible to report mandatory charge revenue and collect sales tax at the same rate as food and beverage purchases.   
For example, if a restaurant in Washington DC collects $50,000 in yearly mandatory charges it will generate a sales tax obligation of $5,000. Depending on how the mandatory charges are coded in the Point-Of-Sale it’s possible that sales tax was never collected (more common for automatic gratuity than service charges) but the employer is still liable to the District for that revenue. In Maryland, mandatory charges are not considered tips but are exempt from sales tax if charged to groups of under 10 patrons for on-premises consumption and passed directly to the employee.
If you jurisdiction taxes service charges, make sure this is being coded into your point-of-sale system and collected from the customer. If you have been non-compliant, It's essential to talk to your finance and legal team to determine your tax exposure and formulate a plan to address and limit any possible tax shortfalls.
The second major area to address is that since mandatory charges are not tips, employers cannot exercise the FICA Tip Credit to offset employer federal tax contributions via  Form 8846 in the same manner they can for tips. Employers are required to make Social Security and Medicare contributions on an employee’s total compensation (including tips) but restaurants can claim a tax credit for a significant portion of their federal tax contributions on an employee’s tipped wages against their federal tax obligations. Mandatory charges aren’t tips so this valuable tax credit cannot be claimed.
A final thing to consider is the classification of employee hourly rate compensation. Listing the cash minimum hourly wage ($5.05 in DC) as an employee’s hourly rate and mischaracterizing mandatory service charges income as tipped income to comprise the FLSA Tip Credit and reach the statutory minimum wage ($15.20 in DC) is an impermissible allocation of the tip credit and could open you up to legal liability, particularly around any overtime compensation. It’s our recommended best practice to pay all mandatory charges as a separate line item to employees during the payroll process.
Here are our keys for making service charges/automatic gratuities:
Revenue Collection: Relevant local sales tax must be collected so make sure any mandatory charges are being added to the pre-tax amount by your Point-of-Sale  and tax is collected and remitted.
Preparation: Examine with your finance team the historical value of the FICA tip credit.
Classification: All hours/employees working for mandatory charges need to be classified as wage earners making at least the minimum wage absent usage of the tip credit.
Choice: If the customer doesn’t have the option to leave any amount they want, it’s not a tip.
As always, you should speak to your Harmony Group Accounting Team and legal counsel so you can fully understand the rules governing the classification of employees receiving service charges and automatic gratuities.