Accounting and Tax Guide for Service Charges, Tips, and Delivery Fees
By Marisa Parker, CPA | Published on 08/02/2021
Through months of unimaginable hardships and uncertainty, restaurants around the country have been rethinking their operations. Uncertainty as to if the restaurant will be open the next day, or if any customers will show up in the next hour, was higher than most had ever experienced even in the most bustling restaurants pre-pandemic.
To counter this, restaurants have needed to reconsider their business model. Some restaurants have implemented or considered implementing mandatory service charges (Autograt) and delivery options with associated fees. When adding these new charges, it is important to analyze the tax and reporting requirements. In this article, we will summarize the tax and accounting implications for implementing services charges, tips, and delivery fees in your restaurant.
Difference Between a Tip and Service Charge
According to the IRS, 4 factors are used to determine if a payment qualifies as a tip:
- The payment must be made free from compulsion;
- The customer must have the unrestricted right to determine the amount;
- The payment should not be the subject of negotiations or dictated by employer policy; and
- Generally, the customer has the right to determine who receives the payment.
With these factors in mind, if you have a charge on the invoice that the customer is required to pay, regardless of the reason, that is considered a service charge.
Here are some common ways fees appear on invoices and where they would be categorized based on the 4 factors above.
|Three tipping options 15%,18%, or 20% plus an open blank||X|
|Mandatory delivery fees||X|
|Mandatory charge of 20% for groups of X or more||X|
|Mandatory charge of 15-20%||X|
Classifying a payment as services charges or tips has different legal and tax implications. We covered these differences in a previous article, which has been summarized in the following table:
|Subject to sales tax||No||Yes|
|Rights and classification||Liability on the Balance Sheet||Income on the P&L, Expense if/when paid out to employees|
|Subject to employer taxes (6.2% Social Security, 1.45% Medicare, SUI (state unemployment), and FUTA (federal unemployment)||Yes||Yes, if paid to employees (not mandatory to pay out to them)
|Subject to employee taxes and payroll tax filings||Yes||Yes, if paid to the employee|
|Tip Credit ($2.13/hr. min wage allowed if the employee earns $7.25/hr. including tips. Employer receives a dollar for dollar tax credit on all FICA taxes paid on tips in excess of the minimum wage.)||Yes||No|
Sales Tax on Service Charges, Tips, and Delivery Fees
Service charges are always subject to sales tax while the treatment of delivery fees varies from state to state. For example, in Washington DC, delivery fees are taxable when the food or drink being delivered is sold for immediate consumption. Tips are not subject to sales tax, as can be seen in the following example:
|Option 1||Option 2||Option 3|
|Tip||Service Charge Only||Service Charge + Tip|
|Service Charge (20%)||200||200|
|Delivery Fee (5%)||50||50||50|
|Sales Tax (10%)*||105||125||125|
|Suggested Tip (10%, 15%, 20%, __ )
*On order total (including the service charge and delivery fee)
As you can see, having a service charge (option 2), passes on additional sales tax to the customer. Suggesting a tip amount is not considered a service charge, since it is still optional to the customer and the sales tax is only collected on the sales and delivery fee.
Sales Tax When Using Third-Party Delivery Apps
An employer’s responsibility for collecting sales tax on service charges and delivery fees can also depend on if a third-party delivery app was used. For instance, in Washington, DC, delivery apps such as Grubhub, Ubereats, and Doordash are responsible for paying sales tax directly to the state, not your restaurant. This can be very easy to miss and can result in thousands of dollars in unnecessary payments. To prevent accidentally paying double out of your own pocket, there are a few solutions:
- Separate third-party delivery sales in your Point of Sale (POS) system with the sales tax percentage as 0%
- Make sure that the sales tax remitted by the delivery service is backed out from the sales tax payable balance that is calculated each month by pulling the amounts from the third-party delivery service reports. This is our favorite method because it requires the least amount of customization by the restaurant.
- Discount the sales from third-party delivery service providers by 100% using a separate discount item in the POS so that sales tax is not calculated on those sales
Payroll Taxes for Service Charges
Any service charge the employer decides to distribute to employees will be an expense and subject to the same payroll taxes as a tip.
The difference between a service charge and a tip once paid out is there is no tip credit for service charges paid to employees. The tip credit allows employers to pay their tipped employees as low as $2.13/hr as long as they receive $7.25 an hour including tips. These minimum wage amounts vary state by state.
Minimum Cash Wage = Minimum Wage – Maximum Tip Credit
$2.13 = $7.25-$5.12
Employers receive a dollar-for-dollar tax credit for all FICA taxes paid on tips in excess of the minimum wage. This is known as the FICA tip credit.
As can be seen in the following example comparing $100,000 paid out in service charges vs. tips in excess of minimum wage, the employer missed out on $7,650 in tax savings
|Social Security (6.2%)||6,200||6,200|
Should I implement a Service Charge?
Despite the fact that a service charge is subject to sales tax and there is no tip credit, the option is still appealing to restaurants for many reasons including:
- Counteract uncertainty of customers tips
- Allocate to other areas (besides only payroll) the restaurant deems important
- Eliminate inequalities in employee pay
There are many legal, operational, and tax implications to implementing service charges and delivery fees in your restaurant. It’s important to understand these implications before making the decision to shift your business model.
If you’re interested in guidance, please feel free to contact us.
Marisa Parker is a licensed CPA who advises and provides outsourced accounting and CFO services for restaurants at RY CPAs.