One of the many new laws going into effect in 2014 will require hotels, restaurants and other employers in the hospitality industry to change their current practice when employees are paid "automatic" tips charged to large groups of patrons. This ruling will not only effect tax withholding, but also require employers to make additional overtime payments to the employees, above and beyond the automatic tip charged to the customer.

Current law requires employees to report their monthly cash "tips" (provided they received $20 or more in the month) to their employer no later than 10 days after the end of the month. Employers are required by law to collect income and payroll tax on these tips as reported by the employee. Cash tips are defined to include tips received directly from customers by cash, credit card or debit card; tips collected and distributed to an employee by an employer; and tips received through a "tip sharing" agreement. The employer is not responsible to withhold employee payroll taxes on unreported tips until a notice and demand is made from the IRS.

The new Rules for 2014
But a new obligation goes into effect on January 1, 2014, affecting all payments made after 2013. The IRS recently issued Rev. Rul. 2012-18 (the "Ruling") to address an employer's tax withholding and reporting of "mandatory tips." Mandatory tips are commonly imposed by restaurants for large parties, and often the menu itself will advise patrons that "an 18% gratuity will automatically be applied on parties of 6 or more."

Unlike tips that subject the employer to tax withholding and reporting obligations only to the extent disclosed by the employee, the Ruling clarifies that automatic gratuities are not "tips" under the law, but rather service charge wages. It is the employer's responsibility to monitor and track all service charge wages, including the obligation to withhold on these wages and report them to the IRS. The employee's monthly tip reporting obligations simply don't apply to these mandatory tips/service charges.

Tips vs. Wages
The Ruling states whether a payment is a tip or a service charge wage is a factual determination, but absent one of the following criteria the payment likely is characterized as a wage (rather than a tip): (i) the customer's payment must be made free from compulsion; (ii) the customer must have the unrestricted right to determine the amount; (iii) the payment should not be the subject of negotiation or dictated by employer policy; and (iv) generally, the customer has the right to determine who receives the payment.

The Ruling gives an example where a restaurant imposes a mandatory 18 percent charge for parties of six or more. In this instance, the customer is not free to pay more or less than the mandatory amount. The Ruling concludes the amount is a "service charge" and thus a "wage" for federal tax withholding and reporting purposes, provided the restaurant distributes the 18 percent charge to employees. Conversely, if the restaurant merely includes sample tip amounts on the bill, and the tip line is left blank, the amount the customer adds to the bill is considered a "tip" for federal tax purposes.

Other legal consequences of payments being "wages"
But the tax consequence is only one facet on how the Ruling will affect employers in the Hospitality industry. Once the "tip" is designated as a "mandatory tip", it becomes part of the employee's wages paid by the employer. This will affect the employee's rate of pay since, as wages, mandatory tips must be included into the regular rate of pay for hourly employees unless a basis for exclusion can be found in the Fair Labor Standards Act (the "FLSA").

If these mandatory tip amounts are not incorporated into the employee's hourly rate pursuant to formulas set forth in the FLSA, the employee's overtime wages will be calculated incorrectly, resulting in an underpayment of wages to the employee. And, to make matters worse, the Ruling may be new, but the obligations under the FLSA are not. We are seeing an increase in class actions alleging the improper failure to include service charges and "mandatory gratuities" into the calculation of employees' regular rate of pay.

Moreover, the US Department of Labor ("DOL") is currently targeting the restaurant industry and we are seeing an increased numbers of investigations across the United States. For these reason, failure to comply with the Ruling may subject a restaurant employer to intense scrutiny not only by the IRS, but also by the DOL and plaintiffs' attorneys.

The federal investigation or class action lawsuit may expand beyond the scope of the Ruling into many wage and hour areas, including minimum wage and overtime classification, and the penalties for any underpayment can include the amount of the unpaid wages, an equal amount in liquidated damages, plus interest and attorneys' fees. State laws pertaining to the non-payment of wages can compound the employer's liability.

What should employers do?
The Ruling highlights the significant risks facing any business that has been treating "automatic gratuities" as tips rather than wages. The New York Times recently reported that a number of restaurants are dropping mandatory tips and service charges. Some are increasing the prices of food to compensate.

In any event, employers should review their reporting practices and payroll calculations regarding mandatory tips and/or service charges. A discussion with qualified legal counsel may be warranted, since the requirements in this area are very complicated, and certain exemptions set forth in the FLSA may apply.