A couple lawyers/Barred in DC followers at Veritas Law Firm wrote this guest post
Guest posters Scott Rome and Dan Koffman are attorneys with The Veritas Law Firm, a general practice DC business law firm with a specialty in hospitality law. Scott is the head of the litigation team at Veritas, has handled numerous employer-employee claims, and has partnered with Andrew J. Kline for over a decade as owners of Veritas. Dan advises hospitality clients on corporate transactional/compliance issues, particularly commercial leasing issues.
[First, let’s get the disclaimers out of the way. This post is for informational purposes only and not in any way meant to provide legal advice. If you have specific legal concerns, be sure to contact a lawyer. Also, we apologize in advance for this post being less entertaining than you have come to expect from this blog. Law firm lawyers can be extremely boring, but if you need one, we believe we are of the less boring variety.]
By Scott Rome & Dan Koffman
We were asked to contribute to this blog, due to the never-ending confusion surrounding tips, service charges, how restaurants can treat tips, and where your money goes when you leave a tip. We will try to provide some information, so that you know where your money might be going, but we are accustomed to tedious legal writing, so maybe Barred can drop a twitter poll about Nashville hot chicken or something in the middle of our post.
Here are some common questions we have seen and the law’s take on each.
Service charges seem to be popping up everywhere during Covid. What is the difference between a service charge, an automatic gratuity, auto-grat, and a standard tip? How are they treated differently by restaurants and what should I know about these charges?
What everyone thinks of as a standard tip or gratuity is treated differently from all other money that comes into a restaurant or bar, because it is discretionary, and considered as a gift from the customer to the employees.
- If the customer determines the amount, it’s a tip.
- If the amount is pre-set on the bill or elsewhere, it’s not a tip, and is revenue of the restaurant.
This simple test determines who can and cannot receive the money, but confusion still exists. Some people believe that if a line item on your check is called a GRATUITY then even if the percentage is set by the business, it has to go, at least in part, to the servers. This is not true. A bar could call this line the “20% Help My People Out Gratuity Fund” and the bar would still be legal obligated to treat it as a service charge, tax it, and be entitled to keep all of it. This does not mean that the owners will often keep it, and sometimes a fund like this is used to make sure that the kitchen staff and others can share in what used to be only for tipped employees.
In DC, there’s no distinction between so-called automatic/mandatory gratuities and service charges. A mandatory gratuity is not discretionary and thus is treated as a service charge. The IRS treats them the same as well, and restaurants must pay sales taxes on these amounts just like any other income. We have had clients suffer an unpleasant OTR audit because they did not pay sales taxes on service charges for large parties. (Some states, like NY, may not tax mandatory gratuities if certain conditions are met, but this is not BarredinNYC, so we will spare you that information).
Tips, on the other hand, are not the property of the business, cannot be kept by the business or managers, and are not considered wages paid by the employer (this affects things like the withholding and payment of Social Security and Medicare tax).
A restaurant/bar has to pay sales tax on service charges and automatic gratuities, but can they charge sales tax to the customer on a service charge / automatic gratuity?
Yes, while a company owes no sales tax on tips, service charges/automatic gratuity are considered the property of the employer, sales tax is required to be paid on such amounts, and thus these charges are often included above the tax calculation line on a bill. People can argue for days about whether to tip pre-tax or post-tax, but with a service charge the restaurant has the right to tax you on top of the charge.
What do you mean that the service charge is the property of the employer? Doesn’t it have to go to the employees?
Nope, there is no requirement that these service charges or Covid-fees go directly or indirectly to any staff. In practice, these are often passed along, and many establishments are requiring service charges right now to make up for employees receiving less in tips, but this remains business income like any other non-tip income. This gives restaurants a lot of flexibility to use the money towards the back of the house and others who don’t get to share in standard tips, but can also be used by the establishment for any other purpose (rent, legal fees, bank loan, legal fees, owner draw, legal fees, anything, legal fees). Restaurants should not use misleading language though, we have seen the AG’s office sniff around when fees are labeled as though they are going to the employees, but kept by the house.
If a business does pay out a portion of the service charge to its employees, how are those payments taxed?
Any portion of the service charge paid out to employees would be treated as wages, not tips. This means the employer must withhold and pay Social Security and Medicare tax on these amounts, may not claim a credit against its tax obligations for these amounts (as it can for tips).
Going back to tips, in the typical dine-in situation where I’m served by a server or bartender, does my tip always go to that server/bartender?
Not necessarily, but it needs to go to “tipped “employees. The business can choose to pool/share tips, with certain restrictions as to how such tips can be pooled: (1) An establishment can mandate the use of a tip pool for all who are allowed to share one by law, provided that all employees are notified of any required contribution amount; (2) Ownership and management cannot share in any tip pool; and (3) Tips can only be shared by employees considered to be tipped employees, unless the employer does not take the tip credit (an employer does not take the tip credit if it pays everyone including servers/bartenders/etc. at least the (non-tipped) minimum wage). In our experience, management dipping into the tip pool has led to many lawsuits, and likely many fistfights.
Why can’t everyone, including cooks, just be deemed a tipped employee?
Well, in a bit of circular reasoning (which is very popular in the law), a tipped employee is defined as an employee who customarily and regularly receives tips AND receives more than $30/month in tips. Those who customarily receive tips are often defined as those who have significant customer interaction, including servers, bartenders and bussers. This gets trickier when employees are serving dual roles, but in order to get more nuanced you should probably contact a lawyer for a consultation (contact us, it’s free). We have had cases where employees were asked to perform dual roles but paid the tipped minimum for all time worked, and this gets you into legal questions like the 80/20 rule, where employees can only be paid the tipped minimum if they spend 80% of their time doing the job of a tipped employee. Either way, the back of the house is left out of standard tip formulations, and this is another reason some places are exploring the service charge model.
Can employers deduct anything from a tip?
Yes, but not much. If a tip is paid by credit card, an employer can deduct a percentage of the tip to use to pay the credit card charge, provided that (i) the employer previously provided notice to the employee of what percentage would be taken out, and (ii) per the Department of Labor, the charge deducted can be no larger than the one taken by the credit card company. In practice, establishments should note this deduction in the paperwork signed by new employees or in the handbook.
I’ve seen a lot of skeleton staffing at establishments due to COVID. What if the only three people working are owners/managers of the establishment? Can they share in the tips since there are no non-owner employees?
These types of hypotheticals are where things start to get more confusing, but we think the better answer is – yes. The restrictions on owners/managers sharing in tip pools stem from federal regulations. Such regulations are most often enforced through employee lawsuits against the employer for improperly paid wages/tips. However, if COVID has led to a business having no employees who can share in a tip pool, then there is no employee present whose rights have been violated by any tip pooling with ownership. So if no non-owner/managers are present, then such laws wouldn’t be applicable/enforceable and such tips could be shared among the owners/managers working by themselves.
OK, I know who can receive the tip left if I do dine-in, but what about takeout tips? Who receives those? I’m not even sure if tipped workers are even present at some of these takeout-only restaurants.
This is where things get even more tricky. For an establishment using the tip credit, the rule is clearly that only tipped employees can share in tips, but it gets harder to follow with takeout. If, for example, there is only one server for outdoor diners and 80% of sales are carryout – is the lone server supposed to get all of the takeout tips? Does the rest of the staff alternate bringing the bags to carry-out customers to ensure they all qualify as those interacting? There is no clear guidance from the IRS or DC, and creative solutions may be necessary to make sure many can share equitably in tips.
The easier scenario comes about when there are either no tipped workers or there is no one receiving the tip credit – then it’s clear that the tips can be shared among all (non-owner/manager) employees. This would be the same as tips left for a barista. A coffee shop usually has no one living off the tipped minimum wage + tips, and there is no back of the house, so the tip splitting is a lot easier.
One last thing to keep in mind is that this area of the law will likely continue to evolve. Looking back over the past decade, both the IRS and the Department of Labor have made significant regulatory changes as to how they treat tips and service charges, so further change isn’t just possible, it’s probably likely. Federal regulations could greatly differ in the next few years depending on the results of November’s election. This was written in 2020, if you’re somehow reading this post in 2032 (congrats on having paid your domain name fees for 12 additional years, Barred!), don’t assume this information is up-to-date.