Think Twice Before Switching to Service Charges

Abrupt increases in operating costs are spurring some restaurants, bars and nightclubs to do away with tipping, instructing patrons not to tip and barring servers from accepting tips. In the place of tips, such operations are charging “service fees” on all checks, fees from 3-20 percent of the patron’s bill. In this practice, the hospitality operators keep the service fees as their income, and don’t pass on the money to servers as tip income. Implemented carefully, the new practice can be legal and helpful to the bottom line. Operators who rush to adopt the new practice, though, are likely to make costly mistakes.

California restaurant owners are feeling the pinch. On January 1, 2016, the state’s minimum wage increased from $9 to $10 per hour. The increase will shift upward the pay scale for all nonexempt employees. Also as a consequence in the increase in the state minimum wage, the minimum salary that must be paid to maintain an employee as exempt will increase from $3,120.00 to $3,466.67 per month.

Aside from the state minimum wage, the wave of cities and counties adopting minimum wage ordinances continues to roll across the state – ordinances that set a minimum wage much higher than even the imminent new state rate. Effective in 2016, for example, the minimum wage in the City and County of Los Angeles will be $10.50 per hour with annual increases each year thereafter. Also effective next year, the minimum wage in the City and County of San Francisco will jump to $13.00 per hour, to be followed by annual increases.

Increased costs of providing medical coverage for employees, particularly for high-end restaurants that want to provide medical coverage, are also contributing to the pressure on restaurants to consider adopting the service fee model.

Here’s the rub: The California Tip Law specifies that money left for servers is the property of servers, not the business: The labor code states: “No employer . . . shall collect, take or receive any gratuity . . . Every gratuity is hereby declared to be the sole property of the employee or employees to whom it was paid, given, or left for.”

Do “service fees” money left by customers as payment for service—belong to the employer or the servers? The state’s tip law defines “gratuity” as any money paid by a patron “over and above the actual amount due the business for services rendered or for . . . food [or] drink . . .”

Unless operators implement a “service fee” program correctly, they risk running afoul of the tip law and being accused of “stealing” money that belongs to their service staff. Operators that charge service fees must, in short, make clear to customers and employees that the service fees belong to the business, not to employees.

For example, restaurant operators should (a) state prominently on all menus that tips will not be allowed or accepted, and that the service fees are charged by the restaurant and belong to the restaurant; and (b) remove the tip line from credit card slips and customer check forms. Operators should also consider requiring that servers, when they first greet guests, explain that no tips will be accepted and that the restaurant charges a service fee, to be kept by the restaurant, in order to help fund wages and employee benefits.

Hospitality operators must also notify the employees of the new rules both in staff meetings and by new written policies, to be signed off on by each service employee.

Other issues: leases and tax questions

Restaurants and bars that lease their business premises are most often on “triple net” leases. Under these leases, operators must pay their landlord a sum as base rent each month plus a percentage of the operators’ monthly or annual receipts. In determining an operator’s monthly or annual receipts, tips are not taken into account, as they’re income to the employees, not the business.

However, service fees charged and kept by the restaurant must generally be taken into account in calculating the restaurant’s receipts under a triple net lease. In other words, unless the restaurant works out some other arrangement in advance with its landlord, restaurants which charge service fees will pay correspondingly more in triple net lease payments to their landlords.

Operators who fail to take this increased cost into account before implementing a service fee plan might be surprised down the road by a landlord wanting a piece of the service fees charged.

Price fixing and tax status

On September 1, 2015, suit was filed in Los Angeles County Superior Court against several high-end restaurants alleging price fixing in violation of antitrust law. The case alleged that competing operators agreed with one another to begin charging a specific service charge to help fund the cost of medical coverage for employees. The suit is pending.

The filing of the lawsuit illustrates a potential risk in competing operators collaborating on possible solutions to rising costs of operation and agreeing to implement coordinated service fee plans.

Traditional tips left by patrons are income to the employees and are subject to income tax payable by the employees. Tip income is not treated as taxable revenue of the employer. Restaurants that follow a traditional tipping model must require their employees to report their tips to the restaurant, which must report the tips along with the employees’ regular wages and apply payroll deductions and withholdings to the reported tip income. The administrative burden on operators of accounting for tips and reporting to federal and state tax agencies is significant.

A service charge model relieves operators of that burden. Service charges are revenue of the employer and are subject to income taxes payable by the restaurant, not the employees.

In short, just as “there’s no such thing as a free meal,” service fees aren’t “free money” for hospitality operators. Service fees have their own consequences on gross and net revenue, legal risks, and the operators’ relationships with their employees and patrons. Implemented thoughtfully, though, service fees may be both legal and helpful.

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