Handling tipped employees and those who receive service charges or automatic gratuities has become a serious legal concern for hospitality employers. With the increase in costly private wage and hour lawsuits and the United States Department of Labor’s beefed-up enforcement efforts, the hotel, restaurant and resort industries are prime targets for tipped employee violations.
To further complicate matters, effective January 2014, the Internal Revenue Service implemented new guidelines for tips and service charges. There are federal and state laws regulating how tipped employees are paid, how and whether tip pooling arrangements can be maintained and how service charges/automatic gratuities are paid and taxed.
Minimum wage for the tipped employee
All non-exempt employees, including tipped employees, must be paid the minimum wage under federal (currently $7.25) and state law (varies). Under the federal Fair Labor Standards Act, tipped employees are those who regularly receive more than $30 per month in tips. Some states may define “tipped employee” differently.
A tip is given by a customer free from compulsion. The customer has an unrestricted right to determine the amount; the payment is not subject to negotiation or dictated by the employer; and the customer generally has the right to determine who receives the payment. Tips include all cash given to the employee, whether directly from a customer or a tip pool, as well as tips charged on credit or debit cards.
Employers must withhold payroll taxes from the tip amount reported. Tips are the sole property of the tipped employee. Any arrangement in which any part of the tip received becomes the property of the employer is unlawful.
Employers must, on a weekly basis, ensure a tipped employee earns at least the minimum wage and receives overtime for all hours worked over 40 (under federal law). Your payroll processor must identify any employee who does not meet the minimum wage, and the employer must supplement the employee’s pay to meet the minimum wage. For a tipped employee for whom you take a tip credit, it is the employer’s obligation to make up the difference if tips do not bring the employee to the minimum wage for all hours worked.
Deductions from an employee’s pay also can cause minimum wage problems. Deductions for walkouts, breakages, uniform expenses and cash shortages, for example, are not permitted in some circumstances and are not permitted if the deduction takes the employee below minimum wage.
Tip credit
The tip credit provisions of the FLSA permit an employer to pay tipped employees no less than $2.13 per hour in cash wages and take a “tip credit” equal to the difference between the cash wages paid and the federal minimum wage. The tip credit may not exceed the amount of tips actually received and, under the current minimum wage, may not exceed $5.12 per hour.
If the employee does not earn sufficient tips for the tip credit, the employer must make up the difference and ensure the employee receives minimum wage for all hours worked. To use the tip credit provisions of the law, employers must:
- inform employees about the use of the tip credit;
- allow the tipped employee to retain all tips, except to the extent that there is a valid tip pooling arrangement; and
- be able to show the employee receives at least the minimum wage by combination of direct wages and the tip credit claimed.
If you are taking a tip credit for any employee, you must provide employees with notice containing:
- the cash wage paid to the tipped employee;
- the amount by which the wage is increased on account of the tip credit;
- that all tips received must be retained by the employee (except for valid tip pooling arrangements); and
- that the tip credit will not apply to any employee who has not been informed of these requirements.
We recommend that the notice be in writing and signed by the employee to avoid later disputes.
Some states forbid the use of tip credit; others impose significant record keeping and notice requirements, and of course, the minimum wage may be different in your state or city. Hospitality employers must follow the strictest of local/state and federal law.
Another area subject to legal challenge is the use of tip credit for employees who perform non-tipped duties such as dishwashing, food preparation and trash removal. The FLSA only permits the use of the tip credit for time spent performing tipped duties. The DOL generally takes the position that if a tipped employee spends “substantial time” (more than 20%) performing non-tipped duties that are “general preparation work and maintenance,” the entire tip credit is lost. Employers should periodically review and control how much “general preparation work and maintenance” is being performed.
Tip pooling
Tip pooling is an arrangement in which all tips are intermingled and then redistributed. Under federal law, an employer may require tipped employees to participate in a pooling arrangement if the employer notifies employees of any required tip pool contribution amount, only takes a tip credit for the amount of tips each employee ultimately receives and does not retain any of the employees' tips for any other purpose. Some states permit tip pooling only if initiated voluntarily by the employees, some limit the positions that can be included in a tip pooling arrangement and some states prohibit pooling completely.
Tip pooling arrangements have been the subject of a good bit of recent litigation complicated by state variations and regulations. Keep these requirements in mind when reviewing your tip pooling arrangements:
- Only employees who “regularly and customarily” receive tips are allowed to share in the tip pool. Dishwashers, janitors and chefs must be excluded from a tip pool.
- Employers are not allowed to share in tip pools. The term “employer” includes managers. An employer is “any person acting directly or indirectly in the interest of an employer in relation to an employee.” Generally speaking, an individual is considered an employer if he or she can hire and fire employees, control the schedule, determine pay rates and maintain employment records.
- Employees may not be required to contribute more than what is “customary and reasonable.”
Tip reporting
To complicate this issue further, the definition of a tipped employee under IRS reporting rules differs from the FLSA.
The IRS defines a tipped employee as one who earns $20 or more per month in tips. Under IRS rules, employees must report to their employer the total amount of tips they receive and provide the employer with written reports by the 10th of the following month. Employees who receive tips of less than $20 in a calendar month are not required to report their tips to their employer but must report these amounts as income on their tax returns and pay necessary taxes.
Service charges and automatic gratuities
Beginning in January, the IRS implemented a new policy for how the hospitality industry treats automatic gratuities. The change aims to crackdown on unreported tip income by clarifying that these automatic gratuities are “services charges,” not tips. Unlike tips, a service charge or automatic gratuity is a compulsory fee. Service charges often come in the form of banquet fees, bottle service or automatic gratuities added to the bill for large tables.
Prior to the IRS’ change, many businesses ensured the sums generated through “automatic gratuities” were distributed to servers and other tipped staff as part of their tips. The employees would then be responsible for accurately reporting and then paying income taxes on these sums. For businesses, like restaurants, bars and hotels, the IRS states the amounts generated by the automatic gratuities are not tips and should instead be recorded as income to the business. The business, in turn, should remit the amounts to the servers as W-2 income subject to normal withholdings. And while businesses may pay wages from these service charges, they cannot, under any circumstance, take a tip credit using a service charge.
To further complicate matters, some states have laws regarding service charges that differ significantly from federal law. In some states, employers must distribute 100% of the service charge to the servers or other members of the wait staff.
If you continue to use a service charge or automatic gratuity, be sure to communicate to your employees how much of the service charge the employees actually receive and factor in the effect that additional compensation may have on the calculation of each employee's regular rate of pay, and consequently overtime payments.
Hospitality employers are easy targets for wage and hour lawsuits and government payroll audits. The laws are complex, so hospitality employers must be diligent about compliance and record keeping.
This article generally discusses issues related to employers’ treatment of tips, service charges and automatic gratuities. The article is not intended as legal or tax advice, and any specific question regarding a particular policy or rule for your workplace should be addressed with legal counsel to ensure compliance with all applicable federal and state laws.
Andria Ryan is a partner in the Atlanta office of Fisher & Phillips LLP and serves as the chair of the firm's Hospitality Industry Practice Group. She represents employers in virtually every area of employment and labor law. Ryan spends much of her time counseling employers in day-to-day employment and labor decisions and educating employers about prevention and practical solutions to workplace problems. She is a frequent speaker to industry groups and human resources professionals on such topics as avoiding harassment in the workplace, maintaining a union-free workplace, avoiding discrimination claims, proper interviewing and effective discipline and discharge techniques. Contact: Aryan@laborlawyers.com, 404-240-4219
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