Tips, Service Charges and Taxes.

Tyler Cowen and Division of Labour are chewing over the legal differences between tips and service charges. (via Newmark’s Door). As someone who has worked as a bartender and waiter in both the US and the UK, may I add a little?

Division of Labour is quite correct in the statement that tips are the property of the server, while a service charge is the property of the restaurant owner, to do with as he sees fit, just as with any other revenue. This has a number of tax implications.

It’s been a couple of decades since I waited table in the US (at a place that Tyler probably knows as well, The Fish Market in Old Town Alexandria. I’d say it’s odds on that one of his undergraduates either does or has worked there and pretty much 100% certain that one of them  is at a similar place. This information can therefore be checked pretty simply) but I think this is still correct.

Jimmy  Carter tried, famously, to tax the three martini lunch. As part of the Congressional logrolling over this a system for the estimation of tip income was introduced. Each server has to have their sales recorded  and it is assumed that 7% of that figure is earned in tips. The waitron unit thus pays income tax on that 7%, plus (I think) FICA.

As we know, tip income is more likely to be in the 12-15% range (allowing for those who stiff) so a substantial portion of a waiter’s income  can be (illegally) tax free. Bully for waiters. (Actually, the way it is usually done is to declare all tips on credit cards plus some small part of cash ones. The risk of an audit if that is done is miniscule.)

A service charge  goes into the regular books of the restaurant. This is of course audited much more strictly. The waiter is now paying income tax and FICA on his entire income, to his obvious disbenefit. Now the restauranteurs are claiming that this allows them to redirect what would have been the tips to the cooks and so on, but it is clearly not beneficial to the waiters. Why would they do that? Especially when there are alternative methods available? Like tipping out.....each waiter gives 10% of his tips to the bartender, 10% to the busboy and, in some places, 10% to the kitchen. Taxman not involved.

There is also the point that a service charge pays sales tax. In NYC that is around 8%. Wages for waiters are tiny, in a good place 90% of income will be from tips. So let’s call it 100% and see what effect this change has.

$100 in tips. Waiter declares half. $50 is subject to both FICA taxes (you don’t think the restaurant is going to pay the employer’s part do you?). 12%. And income tax. 30% both state and Federal? Yes, I know there’s other little bits as well but let’s keep this simple. (And I’m ignoring personal allowances and deductions. This isn’t the first $100 the guy is earning. Back in the mid-80s I was making $1,000 a week doing this job, post tax. A good waiter is on a middle class income and pays middle class tax rates.)

So, $100 in tips and $79 goes to the waitron unit and $21 to the taxman.

$100 in service charge. 8% off the top in sales tax. $92. Then FICA and income tax on the whole amount.$39 ish.

$100 in service charge, $53 to the waitron unit and $47 to the taxman.

Why, after all, reduce the income of your waiters (by increasing their tax bill)? Other things being equal that should lead to a reduction in the quality of waiter one gets. Why, to control the flow of the money, would a restauranteur want to reduce the quality of the pool of applicants into his labour force? It might be, as claimed, that they want to increase the quality of kitchen staff at the cost of reducing the wait staff. My personal opinion is, however, that it is not and this is backed up by personal experience.

Switch to the UK where the legal distinction over who owns tips and service charges is the same but taxation is a little different. I used to work for Kennedy Brookes when they owned Maxim’s just off Leicester Square.

Tips do not pay National Insurance (our version of FICA). They only pay income tax (and at a reduced rate as well, to encourage reporting). This is only true if it is the staff that operate the pooling system (known as a tronc). If the management divide up the pot then it is subject to both sets of NI, some 20% in all. So obviously, no management would get involved, right? They want their workers to maximise their incomes, right? Get the best staff, right?

Well, actually, no.

At the other extreme there is the service charge. This is regular revenue and pays all the relevant taxes. VAT at 17.5%, the two NIs and income tax. Add those all together and you’re talking about 67.5% going to the taxman instead of 25% if the waiters share out the tips themselves.

There is actually a hybrid of this. A "suggested service charge has been added to your bill". Now, if the waiters divide this up, income tax only. If the management, NI as well (actually, technically, if the management do it but pay it in a separate check, then no NI, if it comes in your regular paycheck, then NI.) So those places that do this will, of course, issue two checks, one wages, one tips. Right? Umm, no.

What actually happened way back when was that under a system of "suggested service charge" the management deducted VAT, two NIs and income tax and issued one check with wages and tips.

This was when I was actually doing my taxation course at the LSE so I went round the various tax offices and asked about this system. Shock and horror that we were being ripped off in this fashion. For VAT was not payable.

What ensued was an admission from management that they had been charging VAT to the tips so as to enable them to pay other expenses of the business. Lying to us, in short. There was also the issue of NI contributions to discuss but I left before that was resolved (with a nice large payoff....ssshh Timmy)..usefully, a couple of months before my finals.

Yes, I know this is all terribly long and dreary but the basic issue becomes:

Why would management want to have a system, a service charge, which clearly reduces their workers income? If, as they say, it is to redirect some to the kitchen staff then there are others ways to do that without handing over more to the taxman. But they insist on doing it in a manner that does hand over more to the taxman....so one is left with the conclusion that, as with my ex-employer, they wish to keep some of the money for themselves.

Back to the US system. Why on earth would you reduce your waiter’s income from 79 cents on the dollar spent by the customer to 53 cents? If you weren’t planning to screw them in some other way as well, I mean. It’s simply irrational to cut your staff’s income in this manner. Unless, as I say, you want to get your hands on some of that money yourself.