Hospitality industry employers take note: If you claim a “tip credit” toward the minimum wage for any of your employees, you need to make sure that all tips are properly distributed to employees. A recent case from the Fifth Circuit Court of Appeals involving a Texas restaurant chain illustrates the hazards of making a mistake with the tip credit rules. Steele v. Leasing Enterprises, Ltd. (.pdf)

Here’s a summary of this cautionary tale:

Tip Credit Background

Under the Fair Labor Standards Act, employers are require to pay most employees at least $7.25 per hour. The FLSA allows tips received by employees to count for up to $5.12 of this total, meaning that an employer can pay tipped employees as little as $2.13 per hour so long as their tips are sufficient to make up the difference between their hourly wage and the federal minimum wage. But there are some restrictions. Employers can take advantage of this “tip credit” only if three conditions are met:

  1. The amount of the tip credit taken cannot exceed the amount of tips actually received by the employee.
  2. The employee must be notified about the tip credit. (The U.S. Department of Labor has established specific requirements for the content of this notice.)
  3. The employee must retain all tips received, except to the extent that tips are contributed to a valid tip pool, which may be distributed only among employees who “customarily and regularly receive tips.” (Generally in the restaurant world this means “front of the house” personnel only, not managers or “back of the house” staff.)

This rule is (at least on its face) straightforward enough when an employee receives cash tips, but what happens when a customer puts a tip on a credit card? As anyone who runs a business is likely aware, credit card issuers charge fees for each transaction, including swipe fees, charge backs, void fees, and manual entry fees. When this happens, the DOL permits employers to deduct a pro rata share of the credit card processing fee from an employee’s tips when the tips are paid out.

This can be a tricky exercise because processing fees can vary greatly from company to company and card to card. In one case, the Sixth Circuit Court of Appeals held that an employer can permissibly deduct a share of its employees tips that, over a defined period of time, reimburses the employer for no more than its total expenditures associated with credit card tip collections. Myers v. The Copper Cellar Corp., 192 F.3d 546 (6th Cir. 1999). Other courts and the DOL have generally followed the Sixth Circuit’s lead on this issue.

Deductions Tip the Balance

Leasing Enterprises, Ltd. owns Perry’s Restaurants, L.L.C., which operates a chain of Perry’s restaurants. Perry’s paid its servers a base hourly wage of $2.13 per hour and claimed a tip credit for the remainder of the federal minimum wage. Instead of paying out credit card tips on servers’ bi-weekly paychecks, Perry’s voluntarily paid out servers’ tips in cash each workday. To do this, Perry’s arranged for armored vehicles to deliver cash to each of its restaurants three times per week. When calculating the amount of tips due to employees, Perry’s deducted 3.25% from the total. That number included both the credit card issuer fees and a share of the cost for the three weekly armored car deliveries.

In August 2009, a group of servers sued Perry’s parent company in the U.S. District Court for the Southern District of Texas, alleging that the 3.25% the company withheld from their tips exceeded the company’s credit card processing costs, and therefore precluded the company from counting any tips toward the minimum wage. Both the District Court and the Fifth Circuit Court of Appeals ruled for the plaintiffs.  The Fifth Circuit held that the decision to pay employees’ tips in cash was a “business decision” rather than a “direct and unavoidable consequence of accepting credit card tips.” Accordingly, by withholding an amount that exceeded the direct costs required to convert credit card tips to cash, the company violated the FLSA, and therefore was “divested of its statutory tip credit for the relevant time period.”

Small Error, Big Consequences

Let that ruling sink in for a minute. The District Court found that Perry’s charge of 3.25% was less than 1% higher than the national average of credit card issuer fees. The result of the ruling wasn’t just that Perry’s had to repay that percentage point of tips to the affected employees. Rather, Perry’s was “divested” of the tip credit, meaning that it owed each and every server for whom it took a tip credit up to $5.12 per hour for each and every hour worked over a 2 year period. A single server who worked 1750 hours per year might be owed almost $18,000. Multiply that figure over an entire workforce and we’re talking enough money to put a serious dent in an employer’s finances, if not put it out of business completely.

As bad as that result may be, things could have turned out much worse for Perry’s. The statute of limitations for claims under the FLSA is two years. However, the limitations period increases to three years if a violation is “willful.” A willful violation is one where the employer “knew or showed reckless disregard for the matter where its conduct was prohibited by the statute.” The District Court and the Fifth Circuit both held that the plaintiffs failed to present evidence that the violation was willful, and that the statute of limitations therefore would not be extended to three years.

Employers who are found liable for violating the FLSA are also typically liable not only for the amount of any wages, but also for an equal amount of liquidated damages, unless the employer can show that it acted in good faith and had reasonable grounds for believing that its act or omission was not a violation of the FLSA. Usually, employers can meet this standard only by showing that they investigated their obligations under the FLSA and made a reasonable error despite efforts to comply with the statute. The District Court held that Perry’s satisfied this requirement by showing that it actually looked into its practices and relied on communications with the Department of Labor suggesting that the company’s practices were in compliance with the law. The Fifth Circuit affirmed that judgment on appeal.

Moral of the Story

If you’re going to take a deduction for credit card processing fees, here are a few words to the wise:

  • Figure out precisely what percentage of your credit card revenues go to mandatory issuer fees. Make sure the number is in line with national averages. Keep those records in case you ever need to back up your calculations.
  • This is not a time to be aggressive or creative in your math. Quite the opposite: consider rounding any deduction down to give yourself a margin of error in case your practice is ever challenged. Even a half of a percent error might be enough to trigger huge minimum wage liability.
  • Remember that the FLSA is a floor, not a ceiling. Check your state and local law.

Don’t screw around with your employees’ tips. When it doubt, pay it out!