Income is taxable unless specifically excluded. That means all income. All world-wide income. For your favorite waiter or waitress at your favorite restaurant, the tip you leave them is taxable income. (They do not have to pay taxes on the amount they "tip out" to the cooks, etc.)
If the employee receives more than $20 in direct cash tips during the month, they are required to report it to their employer. (If they fail to report it then they are in violation of the law. They can still directly report it on their personal income tax return and pay the taxes then. If they ignore that income it is your basic tax fraud. IRS Revenue Agents love these - they are easy pickin's. But that's not the point here.) The employer reports the tip amount on their W-2.
All earned income is generally subject to payroll taxes such as FICA and medicare, or if self-employed, then self-employment tax (which is FICA and medicare). So back to our restaurant - the employer must withhold FICA and medicare from the employee's compensation on those tips. They also pay the employer's share.
But wait! The employer (presumably) did not plan on the employer's payroll taxes on the tips given to the employee. So that becomes an extra expense that is a tax. To compensate the employer is permitted a credit of this non-planned tax they paid.
Ever been to a restaurant that states that for parties of 6 (or 8 or 10 etc.) or more, a gratuity of 18% (or 20%) will be added to the bill? Aren't "tips" a voluntary "gift" that are "to insure promptness" by the service staff? How is that automatic "tip" voluntary for the patron?
It isn't. And the law agrees. And the IRS issued Revenue Ruling 2012-18 reminding us of this. These automatic "tips" are in fact a service charge. It all gets treated the same for the employee, but no longer for the employer! A "service charge" is something the employer controls, not the patron. So the employer's share of the FICA and medicare paid to the government on the behalf of the employee can no longer be claimed to be an unplanned expense. That means the employer will no longer qualify for a tax credit to offset that additional payroll tax. Now it is hurting the bottom line of the restaurant!
Some restaurants are already taking steps to eliminate the "automatic gratuity" for larger parties. One aid is to automatically list on the bill the calculated tip amount at various tip rates - to save the patron the effort to calculate it. (OK, to show the patron how much a reasonable tip really is!) Hopefully that works.
Now as part of a large party I will again be able to give generously when the service is good, and reduce that tip when the service is lacking.
For situations where expected tips are used to cover the minimum wage for employees the above works a bit different, but is still applicable. Revenue Ruling 2012-18 is posted at http://www.irs.gov/pub/irs-drop/rr-12-18.pdf.
