The IRS issued Rev. Rul. 2012-18, which provides question-and-answer guidance for distinguishing between tips and service charges for FICA tax purposes, the credit under Sec. 45B for the excess employer Social Security tax an employer pays on tips, and the rules for employer reporting of tips under the notice and demand provisions of Sec. 3121(q).
To determine whether a payment is a tip or a service charge, the IRS cites the factors in Rev. Rul. 59-252:
- The payment must be free from compulsion;
- The customer must be able to determine the amount of the payment without restriction;
- The payment cannot be negotiable or dictated by the employer; and
- The customer should generally have the right to decide who receives the payment.
If any of the above factors is missing, there is doubt that the payment is a tip. Nonetheless, all of the surrounding circumstances must be considered.
Rev. Rul. 2012-18 contains an example illuminating the distinction: A restaurant policy of automatically adding an 18% charge to the bill of parties of six or more is a service charge, whereas a bill with sample calculations of different tip amounts (e.g., 15%, 18%, or 20%), where the actual tip line is left blank, is a tip.
The rest of the questions and answers in the revenue ruling address various issues of tip reporting, including:
- How employees report tips to their employers and how FICA taxes are paid on those tips;
- Whether employees who fail to report tips to employers are liable for the employee FICA tax and whether any penalties apply; and
- Whether, if an employee fails to report tips to the employer, the employer is liable to pay the unpaid FICA tax before the IRS makes notice and demand for payment. The rules for notice and demand are covered in detail in Q&As 8 through 15.
According to a Memo to the Field issued on June 7, 2012 (SBSE-04-0612-057), Rev. Rul. 2012-18 is effective immediately and retroactively. However, because the tip versus service charge part of the ruling described above may require businesses to change their automated or manual reporting systems to comply, the IRS announced that its examiners were being instructed, in limited circumstances, to apply the rules prospectively to amounts paid on or after Jan. 1, 2013. In Announcement 2012-25, the IRS released the memo to the public and requested comments on the memo and whether additional time was needed to ensure that businesses’ systems are compliant.