Restaurant Service Fees Strike a New Nerve: How They’re Taxed

Dan Jacobs, the chef-owner of two Milwaukee restaurants, started using a service charge model during the pandemic to boost pay for his nearly 60 employees, who were seeing fewer tips.

And then he got a $70,000 tax bill, which he said he wouldn’t have had to pay if he hadn’t moved away from tips.

Jacobs, a contestant in the latest season of Top Chef, is one of many restaurateurs across the country who are adding service charges to customers’ checks since the Covid-19 pandemic slammed the food and hospitality industry. But the US tax code favors traditional tipping systems through tax credits, while restaurants that charge fees don’t receive a similar benefit.

Chef Dan Jacobs on Top Chef season 21. Jacobs used a service charge model at his Milwaukee restaurants.

Photo by: David Moir/Bravo via Getty Images

Restaurants use the fees—ranging from single digits to upwards of 20% of the bill—to boost wages for back-of-house workers and remove discrepancies in tipping. Service fees gained an ally in Congress, too, in Rep. Earl Blumenauer, an Oregon Democrat on the House Ways and Means Committee who introduced legislation (H.R.8401) to equalize the way the tax code treats service charges with tips.

“A growing number of neighborhood restaurants and bars are adopting the service charge model to better meet the needs of their workers,” Blumenauer said in a statement. “These restaurants should not be needlessly punished by the tax code for effectively evolving to a changing industry. We need to level the playing field and better reflect the reality on the ground.”

Restaurant service charges seem to be working for a lot of people—just not at the taxation level.

“A lot of restaurants feel like their employees are having to entertain beyond a reasonable measure to earn a tip, and it’s gotten more and more challenging as inflation and all of those other factors have contributed. Service charges are a way to level that playing field,” said Erika Polmer, executive director of the Independent Restaurant Coalition, which is pushing for the legislation.

While the bill aims to bring tax parity between the two systems, it raises questions about whether restaurants with service charges should get a tax break at all.

What’s In the Tax Code

Critics say the service charges reduce how much workers take home at the end of a shift. Labor groups and some restaurant owners prefer tips, which give customers more power and employees more control.

“The benefits here are solely, for tax purposes, to the restaurants,” said Anthony Advincula, communications director for the Restaurant Opportunities Centers United, a group that advocates for restaurant workers. “At back-of-the-house, it’s the responsibility of the employer to provide them at least the minimum wage. It’s not the responsibility of the customers to tip them and it’s not the responsibility of tipped workers to share their tips considering they worked hard for it.”

Restaurants can only qualify for a tax credit under the standard tip system. If a customer at a restaurant is charged $100 for a meal, then tips $20, the bill would record $120 going to the restaurant for tax purposes. But because the $20 tip was passed to the employee—who must pay income tax on that money—the restaurant can claim the tip tax credit against their federal income tax.

The Blumenauer bill would create a similar system to the tip tax credit, allowing restaurants that use service charges to take a credit if the money goes directly to employees.

The new service charge credit under the legislation would apply only to payroll taxes. Only restaurants that use the service charge to pay employees a wage would be able to take the credit.

Customers who are unclear about where the money from service fees goes are likely to feel better with the IRS monitoring, Polmer said.

“You’ve got to document where your revenue is going and how you’re compensating your employees,” she said. “So it takes some of the fuzziness that we currently see in the service charge model that I think really upsets customers and makes it a standardized practice.”

The powerful National Restaurant Association is sympathetic to Blumenauer’s proposal, said Sean Kennedy, executive vice president of public affairs.

“We support policies that allow restaurants to have as much choice as possible in the operation of their businesses—from the tip credit to the use of service fees. We appreciate Rep. Blumenauer starting this discussion,” Kennedy said in a statement.

Milwaukee restaurateur Jacobs underscored that the legislation would leave the tip tax credit in place, but give businesses a choice.

“Right now, there’s no other option,” Jacobs said. “You only have the tip tax credit. That’s it.”

Favoring Tips

Some restaurant workers don’t like the idea of getting rid of tips in favor of service charges, at least not as long as most places in the US still have a tipped wage.

While the federal minimum wage is $7.25 per hour, the rate for workers who receive tips is $2.13.

Seven states plus the District of Columbia have phased out the subminimum wage, and several more are considering doing the same.

Most Democrats in Congress have also endorsed the idea of eliminating the tipped wage, with all but eight voting for a Senate proposal in 2021 that would have done so while raising the federal wage floor to $15 an hour. The provision, which would have been included in the Covid recovery package called American Rescue Plan, failed.

Service charges reduce how much a server is taking home because the fee is spread among multiple workers, including cooks, dishwashers, and others in the back-of-the-house who already make at least the full minimum wage, said Advincula. That makes it harder for those tipped workers to fill the gap between the tipped wage and the full rate, he added.

If a server’s tips don’t bridge the difference between rates, employers must supplement wages to ensure workers receive at least the full minimum wage. Many employers fail to do so, Advincula said.

Ending the tipped wage would solve these problems, he said.

“That’s actually the root of all evils,” Advincula said. “Eliminate the subminimum wage and we go to service charges? Sure, that’s another option.”