Tips and their distribution among the staff have plagued the hospitality industry for years. Federal courts interpret the federal law differently and states have enacted their own statutes that place employers in constant uncertainty, depending on where they are located. Also, tip pooling arrangements have been a regular part of many restaurant operations and are generally allowed by both federal and state law. However, for years there was a lack of clarity and competing interpretations as to who can participate and how much can be contributed to the tip pool. This will provide an overview of the guidelines involving tips, service charges and tip pooling, the current state of the law that was updated on March 23, 2018 and some suggestions on how to stay compliant.
Tip v. Mandatory Service Charge
In a ruling issued in June 2012 the Internal Revenue Service clarified the difference between a tip and a service charge for tax purposes under the Federal Insurance Contributions Act. The IRS determined that automatic gratuities (a percentage automatically added to a restaurant bill) are service charges, rather than tips for tax purposes. Revenue Ruling 2012-18 also determined that to the extent any portion of a “service charge” is distributed to an employee, it is wages for FICA tax purposes.
Generally, the burden of reporting tips falls on the employee. Employees that receive more than $20 in cash tips (cash, debit/credit cards) per month are required to report the tips to their employers by the 10th day of each month. The employer is then required to withhold FICA taxes, similar to non-tip wages. An employer is not liable for their share of FICA taxes if the employee fails to report tips.
However, effective January 1, 2014, employers are required to treat mandatory gratuities as “service charge wages” instead of tips. This directly affects an employer’s responsibility to report and pay FICA taxes, as well as, overtime calculations.
Under the new guidelines, the IRS stated that the difference between a tip and wage requires a factual determination considering all the circumstances. The IRS will generally categorize a payment as a tip (versus a wage) when: (1) the payment is made free of compulsion; (2) the customer retains the right to determine the amount; (3) payment is not subject to negotiation or employer policy; and, (4) the customer determines who gets payment.
As a result, automatic gratuities or service charges are no longer considered tips. Customers do not have a choice whether or not to leave a gratuity and are forced to leave a specified amount set by the employer. Such mandatory gratuities when distributed to the employee by the business are considered wages. As wages, they are not eligible for the FICA Tip Credit (The 45B Credit). For many years, restaurants have benefited from being allowed to apply a general business credit toward a portion of the employer’s social security and Medicare taxes paid on tips in excess of the federal minimum wage as of Jan. 1, 2007.
Also, since automatic gratuities and service charges are not tips, they cannot be included in the tip amount that social security and Medicare taxes are paid on, which takes some tax credit off the table for restaurants. This credit is claimed on Form(s) 8846 and 3800.
However, where a restaurant provides a customer a receipt with recommended tipping amounts i.e… 15%, 18% and 20%, the IRS does not classify the amount left as wages because the customer has a choice to determine the amount, is free from compulsion and determines the amount of the gratuity, if any, left. Therefore, this situation would support a finding that this is truly a tip and not considered wages.
Absent choice by the customer, an automatic gratuity when paid by the restaurant to the employee is considered part of the employee’s wages. This means the burden rests on the employer to incorporate automatic gratuities as part of the employee’s wages as opposed to relying on the employee to report their tips. Service charges/automatic gratuities are considered part of the employees’ overall rate of pay. As such, where a member of the staff works over 40 hours in week or 8 hours in a day in some states like California and receives a portion of the automatic gratuities, this amount must be factored into the total wages earned and factored into that day’s or week’s regular rate of pay (i.e. total wages ÷8 or ÷ 40). It is this figure that is used to determine the overtime rate of pay (1 ½ times the regular rate of pay) for any overtime earned.
This means employers now have the additional burden make sure their pay systems calculate automatic gratuities as part of employees’ wages and use them to determine the regular rate of pay for a particular day or week for purposes of correctly calculating overtime. As such, employers must pay close attention to avoid the underpayment of overtime wages.
History of Federal law as to Tip Pooling
Historically, the federal law on tip pooling adopts standards which are protective of employees’ right to tips.
The Fair Labor Standards Act (FLSA) permits employer-mandated tip pools among employees who “customarily and regularly” receive tips, such as waiters, waitresses, bellhops, bussers and service bartenders. The interpretation made clear that employees who did not directly interact with customers such as chefs, cooks, janitors, and dishwashers were not allowed to share in the money contributed to a tip pool. A court in one case has held that hosts and hostesses who greet customers and perform some table attendance duties might be included in a tip pool. However, this holding was not all encompassing so a case-by-case analysis needed to be applied to determine applicability.
The FLSA forbids any arrangement where any part of the tip received becomes the property of the employer. A tip is the sole property of the tipped employee or employees appropriately participating in the tip pool.
The Department of Labor (DOL) also mandates that the pooling arrangement must be “customary and reasonable” and can not require an employee to contribute a greater percentage of their tips other than what is customary and reasonable. Although there is no definition or exact percentage of what the DOL deems “customary and reasonable,” the wage and hour division has found in cases where contributions of 15 percent or less of an employee’s tips to be acceptable. Contributions of greater than 15 percent are not statutorily forbidden but may require the employer to show that such a percentage is “customary and reasonable” for that community.
States also have similar definitions of allowable tip pooling. An issue of much interpretation and debate is whether employers may mandate that tips/gratuities be pooled and distributed among certain employees as a mechanism for ensuring that gratuities are shared by all employees in the “chain” of customer service and the chain of service over time in the restaurant industry has come to include all non-management employees in states where a tip credit is not permitted..
Pooling tips for redistribution is not required, nor is a written agreement or policy required to allow a tip pool.
“Chain of Service” Eligibility
However, the definition of “chain of service” has continued to be refined and evolve with opinions both by federal and state wage and hour divisions and the courts. For example, in 2005, California’s Department of Labor Standards Enforcement issued an opinion regarding tip pools stated that employees eligible to participate in a tip pool included anyone who contributes to the “chain of service bargained for by the patron, pursuant to industry custom.” This opinion letter described the “chain of service” to include bussers, bartenders, hostesses, wine stewards and front-room chefs (e.g., chefs at a sushi bar or who prepare food at the patron’s table). The opinion reaffirmed that no employer or agent with the authority to hire or discharge any employee or supervise, direct, or control the acts of employees may collect, take, or receive any part of the gratuities intended for the employees as their own. In other words, despite any tip pool container as is often seen at coffee shops, the owner(s), manager(s), or supervisor(s) of the business can not participate in the tip pool, even if these individuals provide direct table service to a patron. This is the case even if the guest intended to leave the tip for an owner, manager, supervisor, or agent of the business who actually provided service to the patron. Given the broad definition of the Labor Code, an agent could include a floor manager or shift supervisor if that person has the ability to direct or control the acts of employees.
However, recent court decisions have allowed shift supervisors in certain situations to share in gratuities. This situation was dealt with in lawsuits by Starbucks baristas as to company’s practice of permitting shift supervisors to share tips. At the Starbucks stores, the collective tip box was divided among the entry-level employees and the shift supervisors. A trial court in San Diego, California initially ruled that California law prohibited managers and supervisors from sharing such tips and awarded over $105 million dollars in damages. However, this decision was reversed with the Court of Appeals holding that shift supervisors are eligible to share in the tip pool, reversing the lower court decision. The Court found that shift supervisors performed the same tasks as baristas because their primary duty was to serve food and drinks. Chau v. Starbucks, Corp. 174 Cal App 4th 688 (2009). This case has not been overturned and even other states including New York cited to the Chau case to support allowing shift supervisors to participate in the tip pool based on their duties being more akin to baristas. See, Barenboim v. Starbucks Corp., 2013 N.Y. Slip Op. 04754 (June 26, 2013) wherein New York highest court found given that shift supervisors performed the same duties as baristas that they could share in the tip pool. Therefore, there seems to be consistency among states as to the role of shift supervisors working at Starbucks. However, consistently courts have found assistant store managers should not be included in the tip pool because they have too many managerial duties, including hiring and firing, so as not to be classified as staff…
These cases have also brought up the concept of a customer service team (consisting of one or more entry-level and one or more shift supervisors) who rotated jobs throughout the day and spent most of their time performing the same customer service tasks, thereby supporting the Starbucks tip pooling arrangement. Generally, a customer who places a tip in a collective tip box was found to understand that it would be shared by all service employees and these cases appear to be guiding law.
As to tip pooling, the industry has adopted a standard that distributes the majority of the pooled gratuities to waiters and waitresses, followed by a smaller percentage to bussers, and a still smaller percentage to other categories of employees who provide limited direct table service. There is no specific cap placed on the percentage of tips waiters and waitresses can be compelled to “tip out”. As will be explained below, the current state of the law has clarified who can participate in a mandatory tip pool.
Tip Credit and Tip Pooling subject to Attack
The most recent issue that has arisen involves who can share in the tip pool and whether “back of the house” employees like dishwashers, food scrapers, chefs, and cooks can share in the tip pool. For years especially under the Obama Administration, the Department of Labor (“DOL”) has consistently taken the position that employees who do not provide direct service to the customer are not allowed to participate in a tip pool. This would mean that kitchen staff who do not have direct service contact would not be viewed as being valid participants to share in a tip pooling arrangement.
However, inconsistent interpretations of the FLSA among various appellate courts have created confusion for both employers and courts regarding the applicability of valid tip pools. In early 2010, when the Ninth Circuit Court of Appeals (which covers the states of California, Nevada, Oregon, Washington, Arizona, Alaska, Idaho, Montana and Hawaii) held that an employer could require servers to pool their tips with non-tipped kitchen and other “back of the house staff,” so long as a tip credit was not taken and the servers were paid minimum wage. Cumbie v. Woody Woo, Inc., 596 F.3d 577 (9th Cir. 2010). According to the court, nothing in the text of the FLSA restricted tip pooling arrangements when no tip credit was taken; therefore, because the employer did not take a tip credit to reach the minimum wage, the tip pooling arrangement did not violate the FLSA.
In response, the DOL on April 5, 2011, issued new regulations that directly conflicted with the holding in Woody Woo. In early 2012, the DOL clarified its position on tip pooling by fully rejecting the Ninth Circuit’s decision in Woody Woo. Therefore, employers could no longer require mandatory tip pooling with back of the house employees. In conjunction with this announcement, the DOL issued an advisory memo directing its field offices nationwide, including those within the Ninth Circuit, to enforce its rule prohibiting mandatory tip pools that include such employees who do not customarily and regularly receive tips.
As a result, several restaurant trade groups and Wynn Las Vegas challenged the 2011 rule change in separate cases, seeking to enjoin its enforcement. (The plaintiff employers all required their employees to participate in a tip pool that included both tipped and non-tipped employees, and they did not take a tip credit against the minimum wage.) Both federal district courts concluded that the DOL lacked authority to make the rule change as a result of Woody Woo and, moreover, that the substance of the DOL’s revision contradicted Congress’ clear intent.; therefore upholding Woody Woo and allowing a mandatory tip pool with back of the house employees states where a tip credit was not allowed..
In response, the DOL appealed but set forth language that it would not seek to enforce these 2011 new regulations within states located in the Ninth Circuit area of responsibility that do not allow a tip credit. On February 23, 2016, a sharply divided panel of the Ninth Circuit Court of Appeals (which covers the states of California, Nevada, Oregon, Washington, Arizona, Alaska, Idaho, Montana and Hawaii) ignored its prior precedent issued in 2010 and upheld the 2011 DOL rule change. The majority concluded that the Fair Labor Standards Act’s (FLSA) “clear silence as to employers who do not take a tip credit has left room for the DOL to promulgate the 2011 rule and rejected the notion that the appeals court itself had foreclosed the agency’s ability to do so by virtue of its 2010 decision in Cumbie v. Woody Woo, Inc., 596 F.3d 577 (9th Cir. 2010). This decision meant that even in states where no tip credit exists that employers can no longer mandate a tip pool distribution that includes employees who are not in the chain of service or have direct contact with customers i. e. cooks, dishwashers… Oregon Restaurant and Lodging Association v. Perez, 816 F.3d 1080 (9th Cir. 2016)).
A petition for rehearing en banc before the full panel of Ninth Circuit judges, rather than the usual three, was requested. On September 6, 2016, the Ninth Circuit denied the petition but ten of the judges joined in a sharply worded dissent that laid out a path for an appeal to the U.S. Supreme Court. The Oregon Restaurant decision is directly at odds with the Fourth Circuit Court of Appeals decision in Trejo v. Ryman Hospitality Props., Inc., 795 F.3d 442 (4th Cir. 2015). Due to this “circuit split”, the National Restaurant Association, the National Federation of Independent Business and other hospitality groups filed briefs to join the Wynn’s prior petition for U.S. Supreme Court to decide whether the DOL acted within its statutory authority when it barred restaurants from including kitchen staff in tip pools. This appeal still is pending with the U.S. Supreme Court and a decision as to whether it elects to take this appeal and resolve the split in the federal courts of appeal is still outstanding
New Federal Budget allows Tip Pooling
In response to the DOL rule adopted under President Obama, the Trump DOL proposed a new rule which would allow tips to be shared and pooled between all employees. Even though this would allow some of the lowest paid employees to receive additional monies from sharing in tips, labor groups opposed the proposed new rule claiming this would result in employers’ managers or supervisors taking tips away from employees. The DOL extended the comment period to address these concerns.
On March 22, 2018, a compromise was reached as part of the omnibus budget bill signed by President Trump on March 23, 2018. Under a rider to the bill, now law, the FLSA is amended to allow mandatory tip pooling so long as the workers are paid at least the minimum wage. This is not an issue in California as a tip credit is not allowed and all employees must be paid at least the applicable minimum wage. Also the rider includes a provision reinforcing the rule that already exists in California that do not allow employers to keep “tips received by its employees for any purposes”. As a result, it reinforces the California rule that the agent of the employer i.e. owners, managers, supervisors are not permitted to share in a tip pool.
In summary, the new budget makes it clear that all employees can share in a tip pool and no longer excludes the heart of house employees like dishwashers, cooks and other kitchen staff. This new rule will help close the large wage gap between front of the house and back of the house workers. Finally, the new FLSA rule does not allow, and has never allowed, restaurant owners to keep employees tips. The tips belong to the nonsupervisory employees, even if the employer helps serve meals and interacts with customers
Practical guidelines for compliance
As a result the new FLSA rules, a company that pays all of its employees at least the minimum wage can l impose a tip pool that allows all non-management employees even those who are not directly in the line of service to be a part of a tip pool arrangement. “Back of the house” employees like cooks, kitchen staff and dishwashers can also share in the tip pool. It is unclear if the U.S. Supreme Court will take the pending appeal given this action as the new rule may have made the appeal no longer necessary.
Going forward, employers should take the following steps to limit liability on tip pooling claims:
A mandatory tip pool can include all line employees even those with limited customer contact as the law has evolved to recognize these employees as being a part of the chain of service for the industry.
If a mandatory tip pool is instituted, the employees with the greatest amount of customer interaction should get the largest percentage of the tips. It is important to make sure that the tip pool is distributed to participating employees in a reasonable manner, proportionate with the employees’ direct interaction with the customers.
Rely more on what the employee actually does in his/her job versus a job title. For example, an employee carrying the title of “waitress” whose only job is to prepare food outside the view of patrons or without personal contact with patrons should receive a smaller percentage of the tip pool. Also an employee who has greater contact with the customer should receive a greater percentage of the tip pool than employees who have less direct interaction with the patron.
It is illegal for the employer to share in the tip pool and therefore, do not distribute any portion of a tip pool to any owner, manager or supervisor, even if the owner manager or supervisor provides direct table service and/or the tip was left by the patron specifically for that individual.
Finally, if a tip pool is instituted, please make sure the tip pool is distributed to participating employees in a reasonable manner, proportionate with the employees’ direct interaction with the customers. It is important to review your current tip pooling arrangement, if you have one and revise it as needed to comply with the new rules.
For more specific questions as to prevention and allowable tip pooling policies, it is important to consult competent legal counsel who understands both the hospitality industry and wage and hour issues and can analyze those issues given your specific circumstances and policies.