Gratuity: a tip or not a tip?

By John Marshall

Most individuals (and dictionaries for that matter) do not differentiate between gratuities and tips. In fact, Wikipedia declares, “A tip (also known as a gratuity) is a payment to certain service workers beyond the advertised bill or fee.” The IRS does not agree.

The IRS views a tip as a discretionary amount given to a worker by a patron, whereas a gratuity is an amount, typically specified by the establishment, of which all or a portion may be conveyed to the employee. Furthermore, the IRS has specified that gratuities are to be paid to the employee as wages on a paycheck.

TRAC agreements have been challenged and overturned due to these monies being pooled with tips rather than separated as pay. (Brinker International Case). The reason for this is clear; gratuities are identifiable, and the IRS does not want to marginalize reporting of tips by including these amounts. Second, gratuities are often at the upper end of the tipping percentage scale, and therefore may artificially raise a server’s overall tip rate. Third, IRS procedures call for any charged sale that has no charged tip to be combined with cash receipts. This detail must be carefully considered, since charged gratuity events would likely have no charged tip, but being a gratuity sale, they are not to be combined with cash receipts and cash tips. If ignored, this would create the illusion of a 18 – 20 % cash tip rate, overstating the true cash tip rate inappropriately. Several years ago I reviewed one such software package that neglected to resolve this detail, and in bench testing, its cash tip rates became impressive, but falsely high, and therefore meaningless.

Unfortunately, most POS systems still do not provide the operator the ability or level of detail to separate the multiple layers of tip and gratuity components necessary for proper declaration to payroll processors, 8027 preparation, and to remain compliant with IRS program requirements.

The reality of the matter is that these paying out gratuity have emerged from a far more practical need to treat gratuities as tips, often cashing them out at the end of each shift. It can be virtually impossible for directly tipped employees to follow their employer’s policy of tipping-out coworkers at the end of each shift if they have little or no cash from gratuity sales. Without a reliable program in place to ensure that shared gratuities will actually and accurately be paid, there is little likelihood that employers will (or could) pay gratuities as wages as required by the IRS. The only viable alternatives are to continue the incorrect practice of cashing out gratuities, to mandate that employees bring enough cash to work in order to properly tip-out their coworkers for gratuity sales, or to implement an automated solution which can manage and track the receipt and reallocation of gratuities payable for the entire establishment. (see review of GrataSoft Solutions, Restaurateur v4).

There are numerous additional benefits for the establishment that pays gratuities as wages. In many cases where credit card use is prevalent, the employees tips declared exceed the net pay available to cover mandatory taxes and benefit deductions such as health and 401(k). By redistributing gratuity as wages, employee paychecks are supplemented, often enough to cover these competing needs. Remember, if your tipped staff receives $0.00 paychecks at all or regularly, it can be safely forecast that they will owe money on April 15th. Furthermore, if you are participating in, or contemplating entering into a tip agreement, removing your gratuities from tips could lower your overall charged tip rate. This in turn would narrow charge to cash declaration rates reducing the possibility of audit. With the ATIP program, rates are specifically pinned to your previous year charge rates, so it could also save the establishment and staff real money through reduced tip declarations.

Now that the Tip Credit may be applied toward AMT, I have been asked if paying gratuities as wages effectively reduces the tip credit by the same amount.  The answer depends on your payroll provider and the wage of the employee.  If the server is paid the traditional $2.13/hr, it is unlikely that their wages plus gratuities would exceed minimum wage.  Make sure payroll providers are aware of, and consider all wages when calculating the minimum wage threashold.  Be sure also to ensure that this value remains fixed at $5.15/hr (as approved), ignoring the Federal Minimum wage increases scheduled over the next few years.

Finally, Washington State now requires operators to show patrons the amount of gratuity that will be conveyed to staff on both menus and checks.  A case is presently underway in New York that suggests that gratuities are all to be paid to staff unless otherwise noted.  In California there is language suggesting that if a gratuity is added "as a convenience" then the gratuity is considered a tip and belongs to the employee.