In June 2012 the IRS issued Revenue Ruling 2012-18, explaining the difference between a tip and service charge, and emphasizing that services charges are wages. While both service charges and tips are subject to employment taxes, there are different reporting obligations associated with each category. Also, importantly, as wages services charges do not qualify for FICA tip credit under Internal Revenue Code section 45B.

In order to give businesses time to transition their reporting systems in situations where they may have been treating services charges as tips rather than wages, the IRS delayed implementing its Revenue Ruling. The Ruling will now go into effect on January 1, 2014, and the IRS will begin enforcing the service charge versus tip distinction and take steps to ensure that service charges are being properly classified and reported.

The IRS also recently clarified that “mandatory tips” – often imposed by restaurants for parties larger than six or eight patrons – are service charges and thus wages rather than tips. This clarification potentially has significant implications for businesses that had been treating “mandatory tips” as tips rather than wages. The designation of “mandatory tips” as wages may have not only employment tax implications, but also wage rate implications because, as wages, mandatory tips may impact the regular rate of pay for hourly employees.

In light of these changes, employers with tipped employees should review their treatment of all forms of tips and service charges and ensure they are properly reporting and classifying them for both tax and hourly rate-calculation purposes.