How service charges could be killing your restaurant…

Despite IRS revenue ruling 2012-18 which took effect on January 1, 2014, many restaurants continue to charge large parties a service charge or automatic gratuity upon checkout. Although there is nothing wrong with mandatory service charges, chances are these restaurant owners are not fully compliant with IRS law. If they were fully compliant with IRS law, they would have been advised to dump this practice a long time ago. Many full-service chain restaurants ended these practices because they received guidance from the proper accountants and lawyers, others not so much.

Lets assume the following example: Company A hosts a 10 person dinner meeting at your full-service sea food restaurant in Washington, DC. The bill totals to $1,000 and you have a policy to apply service charge of 20% to groups of 6 or more. The 20% gets split 15% to the tip pool and 5% to the house or to an events manager. Seems pretty simple right? Think again. Here are the added complications and negative consequences when mandatory service charges are applied:

  1. Sales tax is calculated on the total bill plus the service charge. Yes, I know you’re probably not doing that correctly either, but I digress. So now your guests are paying $20 more in sales tax. $1000 for food + $200 service charge + $120 sales tax ($1200 X 10%) vs $1000 + $100 sales tax + $200 tip. Your customers will be unhappy about the extra tax so the only entity who wins here is the DC government.
  2. The $150 that gets allotted to the tip pool should be reported as wages, not tips. This adds another complication in recordkeeping because now you must keep track of a service charge pool in addition to your tip pool.
  3. As a result of reporting service charges as wages, not tips, you will not receive the benefit of the FICA tax credit on these wages. Restaurant owners receive a tax credit for FICA taxes (7.65%) paid on tips. The credit is typically calculated per employee. Once the employee’s pay reaches $5.15/hr after considering hourly wage and tips, the excess tips multiplied by 7.65% is the owners tax credit. In most full-service restaurants, tipped employees are compensated in-excess of $5.15/hr so the restaurant owners almost always benefit from this credit. With that said, a restaurant is losing out on 7.65% of tax credit on all the service charges that are paid out as wages instead of tips.
  4. Applying a mandatory service charge will (in most cases) not incentivize servers to offer a superior level of service, thus diminishing your restaurants reputation.

If the 20% tips were voluntary tips (not service charges), the process would be simpler. Sales tax would get calculated on the food sales only, and the 20% tips would flow straight to employee tip pool and get paid through payroll as tips (not wages).

Since the enforcement of revenue ruling 2012-18, many restaurants have done away with mandatory service charges mostly because it is not worth the headache and complication. In most cases, the cost of implementing a compliant service charge program (due to extra recordkeeping costs and forgone FICA tax credit) outweighs the benefit of the mandatory service charge. There are beneficial alternatives to mandatory services charges that are IRS compliant. For example, we recommend adding a “Recommended Tip” line along with a 3-5% service charge that goes directly to the house. Before acting you should consult with an expert to determine the best solution for your business. RY CPA specializes in restaurant accounting and we are happy to help you build a profitable and compliant business.

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