Service charges are in the headlines more than ever. Many restaurant owners are rethinking their wage model to maintain a competitive advantage during a labor revolution. In this article, I will discuss:
- Changing wage models
- The differences between a tip and a service charge
- Sales tax on service charges
- Payroll taxes for tips and services charges paid to employees and the tip credit
- Hidden costs of service charges – increased insurance and rent
- The effect of service charges on overtime calculations
- How to properly analyze labor costs
- Other factors to consider (pay inequality, allocation to other areas of business, uncertainty of income)
Changing Wage Models
Most states continue to provide benefits for a tipped wage model, but many restaurateurs are aware that change is on the horizon if not already in the works. Some benefits for the tipped wage model include a low minimum cash wage paid to workers by the restaurant that can be made up by tips from customers, as well as additional payroll tax incentives through tip credits. The following states have eliminated the tipped wage practice:
In November 2022, Washington DC followed suit by passing Initiative 82. Many in the industry throughout the rest of the country are watching to see if that will spark the fire for the rest of the country to overturn tipped minimum wages. Under Initiative 82, the tipped minimum wage in DC will go up from $5.35 an hour to $16.10 an hour. This will essentially put the cost of labor back on the restaurant.
To counter this change, restaurants are reconsidering their business model. Some restaurants have implemented or considered implementing mandatory service charges (sometimes misleadingly called Autograt) and delivery options with associated fees. When adding these new charges, it is important to analyze the tax and reporting consequences. In this article, we will summarize the tax and accounting implications for implementing services charges, tips, and delivery fees in your restaurant.
How to Identify a Tip vs a 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|
Make sure services charges are clearly listed as a service charge that is required to be paid and the customer is aware that it does not go to a specific employee. If the fee does not specifically say “service charge”, has the option of removal, or has the word “gratuity”, the customer could get confused and think it an optional amount and that it goes directly to the employee. In that case, it is considered a tip for legal purposes, which is property of the employee.
Classifying a payment as a services charge or tip 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. minimum direct cash wage (wage needing to be paid out of pocked) allowed if the employee earns US Federal minimum wage (currently $7.25 / hr) after 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|
*This varies by state as not all states use the federal minimum direct cash wage for tip credits and the amount are increasing consistently with increases in minimum wage. For example, in DC, the minimum direct cash wage increased by 6% to $5.35 since the minimum wage was increased by 6% to $16.10 on July 1, 2022 so there is currently a maximum tip credit of $10.75 (current as of December 2022).
Responsibility for Sales Tax
Service charges are always subject to sales tax while the treatment of delivery fees varies from state to state. Tips are not subject to sales tax, as demonstrated in the following example:
|Option 1||Option 2||Option 3|
|Tip||Service Charge Only||Service Charge + Tip|
|Service Charge (20%)||0||20,000||20,000|
|Delivery Fee (5%)||5,000||5,000||5,000|
|Sales Tax (10%)*||10,500||12,500||12,500|
|Suggested Tip (10%, 15%, 20%, __ )||20,000||20,000|
*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 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, check out the solutions discussed in our previous article for Toast POS.
Payroll Taxes for Service Charges – Same as a Tip without the FICA Tax Credit
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.
Any FICA payroll taxes considered for purposes of the FICA tip credit cannot also be deducted as payroll tax expense. This reduces the overall tax benefit of the credit. As can be seen in the following example comparing $20,000 paid out in service charges vs. tips in excess of minimum wage, assuming a 30% tax rate, the employer missed out on $1,071 in additional tax savings.
|Social Security (6.2%)||1,240||1,240|
|Tax Savings from Payroll Tax Deduction ($1,530 x 30%)||459||0|
|Total Tax Savings||459||1,530|
Hidden Costs of Services Charges: Increased Rent & Insurance
As discussed previously, since service charges are the property of the employer and hit the profit and loss statement, service charges are considered income when received and an expense when paid out as wages.
This income that is received can indirectly increase rent expense if rent is calculated by the landlord using a percentage of sales. When negotiating with landlords for your rental agreement, try to negotiate to leave service charges out of the sales calculations as these can be considered more like a contra-wage expense account, or reimbursement for wages, than a sales account.
The wage expense paid out can indirectly increase insurance expense. Workers compensation insurance premiums can be calculated using the following estimate:
Workers’ Classification Code Rate x Experience Modification Number x (Payroll/$100) = Premium
Since the premium calculated uses the total payroll paid to the employee, the service charges paid out as wage expense will be included in the calculation. Tips are excluded from this since they are not considered wage expense, just a reduction of the tip liability owed to employees.
How Service Charges Affect Overtime Calculations
When switching to a service charge model, the service charges paid to employees need to be factored in when calculating overtime rates for employees as shown in the following example.
Let’s assume an employee worked 60 hours a week for a year and earned $20,000 in service charges.
For this example, we assume she is paid using the federal minimum of $7.25/hour.
A – Minimum Wage = $7.25
B – Hours worked = 3,120 (2,080 regular + 1,040 overtime)
|Scenario 1||Scenario 2|
|Total Wages (A x B)||22,620.00||22,620.00|
|Total Pay (C)||22,620.00||42,620.00|
|Regular Rate (D) *||7.25||13.66|
|Overtime Premium **||3,770.00||7,103.20|
**D x .5 x 1,040 hours of overtime (3,120 hours worked-2080 regular hours per year)
The service charges increased the employees’ base rate by $6.41/hour ($20,000 service charge/3,120 hours worked). While the total pay includes the service charges, since it is recovered with service charge income, the main difference here between the service charge model and the tip model is the overtime premium.
As you can see, this is a calculation that would need to be manually made each payroll for all applicable employees since payroll software does not factor in service charges so any overtime should be avoided at all costs. Many restaurants will end up reducing hours to make up for the increase in labor cost, to help mitigate this issue.
How to Analyze Labor Costs Including Service Charges
While service charges will be considered wage expense, tips paid will be considered a reduction of the tips payable liability and not included in the labor cost number. Let’s analyze labor costs using 3 different scenarios. Sticking with the previous example of $20,000 of tips/service charges paid out, let’s say one year you pay $30,000 in wages and make $100,000 in sales.
- Scenario 1 – Your employees make an additional $20,000 in tips, included in tips payable
- Scenario 2 – The $20,000 is service charges, instead of tips, which is included in wage expense and income
- Scenario 3 – Same facts as scenario 2, except instead of including in wage expense and income, the service charge is considered as a contra-wage account
|Scenario 1||Scenario 2||Scenario 3|
|Labor Cost Percentage||30%||42%||30%|
* Includes the $20,000 in service charges paid out as wage expense
** Includes the $20,000 in service charges received in income
*** 30,000 + (20,000 in service charges wage expense paid to employees – 20,000 service charge contra-wage expense recovered from customers)
If the service charges are analyzed how they are in scenario 2, this number can seem misleading since for essentially the same transaction as scenario 1, the labor cost percentage increased by 12%.
To avoid this scenario, you can track service charges as a contra-wage account for service charges paid out to the employees, like in Scenario 3.
This way a true analysis can be made on the profitability of the wage expense you pay to employees as a percentage of sales from the food sold without regard to wages covered by service charges from customers.
While the labor cost did not actually directly increase when switching from a tipped minimum wage model to a service charge model, it is important to plan for the increase in the following expenses previously mentioned by making sure service charges received from customers cover the increase in the following costs:
- Workers’ compensation insurance premiums
- Overtime premiums (can be avoided if limit overtime)
- Rent expense (if unable to negotiate to exclude services charges from percentage rent calculations)
- Reduction in tax savings due to losing the FICA tip credit (usually not a huge difference due to the lost deduction for payroll tax expense)
- Sales tax
How is the Service Charge Model Beneficial?
Despite the fact that a service charge is subject to sales tax, has no tip credit, and can indirectly cause an increase in other costs, the option is still appealing to restaurants for a handful of reasons:
- Counteract uncertainty of customers tips
- Allocate cash from service charges 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.
By Marisa Parker, CPA, a licensed CPA who advises and provides outsourced accounting and CFO services for restaurants. | Published on 08/02/2021