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IRS Ruling on Non Discretionary Service Charges

As a general rule, employers are not required to withhold taxes on tips that are not reported by the employee. However, pursuant to a recent Internal Revenue Service (“IRS”) ruling, effective January 1, 2014, non-discretionary service charges and/or automatic gratuities added to a bill or fixed by an employer that the customer must pay and which are paid to an employee, will no longer constitute a “tip” but will rather constitute non-tip wages that are subject to applicable withholdings. It is now the employer’s responsibility to monitor and withhold taxes on these automatic payments, even if they are not reported as “tips” by the employee.

According to the IRS ruling, a tip is narrowly defined as: (i) an amount of money presented by a guest free from compulsion; (ii) a payment that the customer has the unrestricted right to determine the amount of; (iii) a payment whose amount cannot be the subject of negotiation or dictated by employer policy; and (iv) generally, a payment in which the customer can dictate and determine the recipient. If any of these four factors is absent, the automatic or non-discretionary service charge is not a tip and if any portion of the charge is distributed to an employee, it is considered wages for FICA tax purposes.

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