24 Jul The Deep End of the (Tip) Pool
What are the odds of getting caught breaking the law and what’s at stake?
In the U.S. about 11% of restaurants are audited each year by the IRS. The last time you got scared it was about how service charges are handled. This time you should be VERY scared if you have a tip pool. If you can’t afford to pay three times the payroll you have been paying, don’t be complacent, keep reading. If you disbelieve restaurant IRS audits are at 11% per year, understand you might not even be notified you’re being audited. Some audits are done without a visit, determining if an in-person investigation by an agent is cost effective for the dollar amount that would be recovered. It doesn’t mean you weren’t found in violation of something if you aren’t contacted, it might mean they’ll continue watching until the recovery figure is higher.
All it takes is one employee complaint. Although tip handling involves the Department of Labor (DOL) and not just the IRS, bar/restaurant owners have potentially business-killing penalties at stake when the tip pool rules haven’t been followed and the business gets investigated either from a complaint or audit. With more aggressive workers’ protection efforts being pushed at the state level, especially around minimum wage, exactly how much income is generated by tipping is under the microscope, which means tip pools are too. The IRS catches invalid tip pools when they investigate payroll tax payments and tip reporting fraud. The DOL catches invalid tip pools mostly through employee complaints.
The system servers in restaurants and bars use to redistribute tips, frequently called “tipping out,” has more regulation than most people know. You aren’t alone in doing things wrong, but handling tips “the way everyone does it” is a serious problem because the majority of employers break the law in this area. It’s an issue both for employees who lose significant income participating in invalid tip pools, and if you’re the bar/restaurant owner those incorrectly redistributed tips will come out of your pocket if you’re caught with an invalid tip pool. Not only will the tip recovery dollars come out of your pocket, but you might be made to pay more than triple the payroll dollars for the entire period you have had an invalid tip pool! It is the employer’s responsibility to know and obey the law. And unfortunately it seems so few get proper legal advice in handling tip pools, even in huge restaurant chains, that the problem exists in most bars and restaurants with a tip pool. This article aims to get everyone on-board with understanding the current law and away from behavior that could end the business.
Know the fundamentals:
First understand there is no such thing as a “tip out.” That’s slang and unfortunately its use confuses the issue because it makes it impossible to tell from the nickname which of the two tip redistribution systems is actually being used. There are only two systems. They are differentiated by whether the redistribution of tips is mandatory or voluntary. Any system that is voluntary is a tip share. Any system that is mandatory is a tip pool. Tip pools have been regulated by law for decades. This is not new law, though there is active debate over certain details. Awareness is what’s changing most recently.
Tip sharing by definition is 100% voluntary. Employees cannot be coerced to participate. Because it’s voluntary, there is no regulation on how much money or to whom an employee can choose to voluntarily give to another worker. When participating in tip sharing, the redistributions still need to be recorded in the employee’s daily tip record so the employee isn’t required to pay taxes on money redistributed this way, the receiving employee is. There are some places with tip sharing that also have misguided co-workers who try to use guilt to make other employees participate who don’t want to. This attempted coercion is illegal. Tip shares MUST remain voluntary. Some employers encourage or pressure employees to establish tip sharing and it seems to employees that are not participating will result in termination, reduction in hours, or other undesirable things. This employer pressure is also illegal, and urging tip sharing is sometimes a masked substitute for the employer who doesn’t want to have to follow strict tip pool regulations.
“I won’t be liable because I leave tip-outs to the employees.”
False: Washing your hands of how tips are redistributed does not eliminate your responsibility as an employer to make sure there is no coercion involved.
A tip pool exists any time redistribution of tips is mandatory. It doesn’t matter if you call it something else. It’s a tip pool by its mandatory nature, not by declaration. Because participation in a tip pool is not optional for employees, employers must follow several laws regulating this scheme of redistributing money. There are a handful of basic rules that govern whether a tip pool is valid or not. If the scheme does not follow ALL the rules it is invalid, and no employee can be forced to participate in an invalid tip pool. No employer may claim a tip credit if an invalid tip pool is in place. Here are some questions to ask about your tip pool to know if it is valid or invalid. Tip pools are regulated at the federal level by the Department of Labor (DOL) under the Fair Labor Standards Act (FLSA). Fact Sheets #15 and 15A provide much of the information about tip pool regulation and law, but not all of it.
Q1) Did each employee received a written copy of the tip pool specifics detailing how the tip pool is calculated, to whom the redistributed funds would go to (by job title), and did the employee agree when they were hired?
Detail: All tip pool conditions must be in writing and a condition of hire.
Q2) Have employees been instructed on how to use IRS Form 4070A (Daily Tip Record) to log redistributed tips to other employees, and the consequences and benefits of reporting accuracy? Does the employer collect form 4070 from employees and reconcile at least monthly as required?
IRS Red Flag: Some employers use the point-of-sale to automatically record tips received by a server, even forcing specific percentages of sales to be entered before the employee can clock out. This is non-authoritative method of recording tips. The ACTUAL amount of tips is what must be recorded by the employee, not some artificial or minimum percentage of sales. The ONLY authoritative document is the tip report the employee turns in to the employer. The employee does not have to use form 4070A, but each employee must maintain a daily record that includes the IRS required information when reporting tips to the employer. The POS may be used as a reference and generate a discussion with an employee if reported tip amounts do not seem to match recorded POS transactions, but the employee’s report of tips is what the payroll accounting must be based on. Using the POS to track tips paid by credit card does not waive the employee’s independent reporting requirement and authority.
Detail: All redistribution of funds must be recorded by the employer. It is still the employee’s responsibility to record tips received and tips redistributed. The employee must turn in a daily tip report to the employer by the 10th day of each month for the month preceding. Some employers may ask the daily tip record be turned in weekly to keep accounting current within the next pay period. If the report is filed less frequently, it means the employer may need to adjust payroll deductions on previous pay periods. The IRS provides form 4070A and 4070 for this reporting purpose in IRS Publication 1244.
Q3) Is anyone with a job title not included in the following list receiving any money from a tip pool? Waiter/waitress, bellhop, counter personnel (who serve customers), busser (includes server assistants), service bartender.
ILLEGAL: Since 2011, only job titles listed on FLSA Fact Sheet #15 may participate in a tip pool. These titles are all persons who customarily and regularly receive tips. This excludes dishwashers, cooks, chefs (but allowing sushi and teppanyaki chefs, otherwise known as performance chefs, and sommeliers), laundry room attendants, salad preparers, prep cooks, and janitors. If the title is not explicitly mentioned, courts have set precedent that employee should not be included in the tip pool, for example hosts or expeditors. Unless your host or expeditor is also your busser, which is an explicitly allowed title, they are considered excluded from participation in a valid tip pool. Management and owners are always excluded from participating in tip pools even if they also perform some tasks that would otherwise earn tips. Management may earn individual tips, but cannot participate as a beneficiary in a tip pool.
Q4) If tipped employees are paid a sub-minimum base wage, have you neglected to deduct the amount of tips required to reach minimum wage (called “net tips”) before calculating the employee’s tip pool contribution?
ILLEGAL: When a tip credit is claimed by an employer, no tip monies required to bring the employee to minimum wage can be used to calculate a contribution to a tip pool.
Detail: If the state does not have a sub-minimum tipped wage, the ‘net tips’ element does not apply.
Q5) Does the amount contributed to the tip pool by an employee exceed 15% of net tips received?
WARNING PER CASE LAW: DOL does not set a maximum tip pool contribution amount. Even so, lawsuits have risen from large redistributions. In the 1978 opinion letter from WHD, the maximum amount of money that an employee would be expected to contribute to a tip pool is 15% of NET tips. Net tips are figured by deducting any amount required to reach minimum wage. That means if a server is earning a base wage of $2.13/hr any tips required to reach $7.25 (or higher if the state has a higher minimum), must be excluded from calculating the subsequent contribution to a tip pool).
Detail: The 15% figure is a DOL guidance figure defined as the “customary” amount. It has been used as a de facto standard in court cases, though it is not a law. “Wage and Hour Opinion Letter WH–468, 1978 WL 51429 (Sept. 5, 1978)” A few municipalities, proved in court that it was “customary” for a higher percentage (20%) to be redistributed and won against complaints. If you do not like the splits, the staff needs to renegotiate the terms of the tip pool, but distributions still cannot be based on a percentage of sales. It must be based on some designated portion of net tips. Other examples of further state regulation of tip pool conditions can be found at https://goo.gl/6tjF62
Q6) Is the employee contribution to the tip pool based on a percentage of sales? (This is the factor that most frequently invalidates a tip pool.)
INVALID PER CASE LAW: Contributions to a tip pool may only be calculated as a portion of actual (net) tips received. This condition is not an explicit law of its own, it is a combination of a guidance document from the Department of Labor, and two existing laws that protect tipped employees for other reasons.
Detail: The tip pool contribution cannot be based on a percentage of sales. The basis must be a portion of actual net tips received. An example scheme that designates 5% of liquor sales goes to the service bartender is invalid. This is where two existing laws protecting tipped workers come into play. Case law invalidating tip pools based on a percentage of sales uses these two previously existing federal laws on tipping in general:
1) Tips are property of the server (and may not be taken)
2) No money may be taken from an employee that would bring their wage to below minimum wage to pay for something
The courts decided that there was an unacceptable RISK for tipped employees if tip pool contributions were based on a percentage of sales. Sales amounts (and tip amounts received) are both outside the control of the employee, so sales percentages are an unreasonable basis for calculations. In some such circumstances an employee might be asked to surrender unearned amounts of money, such as if an employee received zero tips on a bad day and was expected to contribute a percentage of sales to a tip pool. This would violate the law protecting employees from being reduced to less than minimum wage. Or if actual tips received were low, a percentage of sales might create a situation where the tipped employee keeps a share that is smaller than others in the tip pool. Examples of case law related to this can be found at https://goo.gl/DYf2Vd Whether the actual tips received create this bad situation or not isn’t the important factor, the RISK that it could happen is enough to invalidate ‘percentage of sales’ as a basis for calculating tip pool contribution.
Because the customary outgoing share is <15% of net tips, the originally tipped employee should retain the vast majority of all tips received. Whether the tip amounts actually received were low or not, the courts decided that the risk was unacceptable, and that tip pool contributions could NEVER be based on a percentage of sales. They should always be a fraction of actual (net) tips received.
Q7) Do you have a shared tip jar divided among multiple employees?
SPECIAL CASE: The tip jar is treated as a form of tip pool but must follow regulations. What’s confusing here is that if you agree to a tip jar version of tip pooling even though a customer puts the tip in the employee’s hand as an individual, that tip money is not the employee’s property yet. It goes into the tip jar. Only after the tip jar is split following the tip pool distribution scheme does the tip money become property of the employee.
Q8) Does your POS system require an amount of tips to be recorded by the employee before they can punch out?
IRS RED FLAG: The point-of-sale system may assist an employee in counting the tips received by credit card, but it is not the authority on recording tips. Employees must turn in their own tip report to the employer, and ONLY that document is the authority on tips received. If the POS sets a minimum or specific percentage of sales to be entered as tips (cash or credit), this is a high-risk factor for IRS audit, as it creates a recognizable pattern in reporting, and is an incentive for employees to enter fraudulent figures just so they can clock out. It may also require employees to enter inaccurate figures when actual tips are lower than the pre-set percentage. Never ask employees to report tips this way.
Q9) Are you in Kentucky, Minnesota, New Hampshire, North Dakota, or Wyoming?
NOT ALLOWED: Mandatory tip pools are not allowed in these states. Truly voluntary and free from coercion tip shares are permitted.
Detail: In North Dakota a mandatory tip pool is only allowed if 50% + 1 tipped employee vote to have a mandatory tip pool. The request to vote must come from tipped employees, and the employer must record all votes.
Penalties are steep!
The penalty for an employer found to be operating an invalid tip pool starts with liability for all incorrectly distributed funds. The employee who received more money in a tip pool than they should of will not have to surrender that money. The employer will be expected to reimburse the employee from whom the funds were incorrectly taken as part of an invalid tip pool agreement. Additionally, if the employer claims a tip credit for tipped employees, the tip credit is invalidated for the entire period during which an invalid tip pool was in place. This means the employer owes the full minimum wage to all employees who were earning the sub-minimum wage for any hours worked while the invalid tip pool was in effect. These back wages can be substantial in addition to the incorrectly distributed funds from the tip pool.
Example: $2.13 sub-minimum wage, $7.25 federal minimum wage, (difference of $5.12/hr), 10 tipped employees averaging 350 hours of combined labor per week, invalid tip pool in place for one year, unpaid wage liability for employer $93,184 plus payroll taxes also owed by employer!
Enforcement of tip pool laws rarely occurs without a complaint to DOL from an employee or an IRS audit. Some state level labor departments like New York State are more proactive and initiate investigations without prompting by a complaint. In New York State more than $20million is recovered annually for employees who suffer wage violations such as invalid tip pools and other wage problems. This proactive investigation is becoming more common as awareness increases of how invalid tip pools are affecting tipped employees.
Employees: If your employer won’t correct an invalid tip pool and you need to file a complaint, call the federal DOL at (866) 487-2365, Monday through Friday 8a-8p ET. This is the place to start if you want to recover incorrectly redistributed funds related to an invalid tip pool, if your employer still chooses to break the law after becoming informed.
Other ethical questions of tip pools:
Aside from regulation, some employees complain that they don’t feel other workers “earn” their slice of the redistributed tips. One example is a busser who doesn’t do their job well and the server ends up doing half of the work bussing work, but the amount of the tips going into the pool remains the same even if the amount of support work diminishes. Another example is the service bartender receiving a portion of pooled tips whether or not any drinks are made at the bar during the shift. These are management issues not governed by law. It is a good reason to discuss the terms of a tip pool among the entire staff if they are unsatisfactory now. Some of the issues are solved when management understands that tip pool contributions cannot be based on a percentage of sales. Performance complaints and employees who shirk work are different than legal issues; they’re management and company policy issues. When all of the staff has enough information to speak with authority about the primary tip pool regulations things tend to change because the tip pool terms have a standardized foundation.
Advice for handling tip pools the right way:
Although it might be nice if tipped workers were either able to handle all the labor of service on their own and not have a reason to share tips with support staff, the reality is that in creating efficient systems with dedicated tasks, service can sometimes be improved. It’s also true, as an example, that the bartender takes away some time from customers seated at the bar to provide service to waitstaff on the floor handling tables and wouldn’t see tips from that portion of labor without a tip pool or tip share. There are valid reasons to support using tip pools.
Don’t make mistakes that risk your business by being sloppy. Set up a tip pool the right way. As noted earlier, most employers get it wrong, even big national restaurant chains. Once you are fully informed about the laws and regulations of what constitutes a VALID tip pool, you can set one up correctly with no added difficulty. This article is not legal advice, and employers should always consult a local labor attorney before finalizing or fixing your tip pool system to make sure it complies with all nuances of all governing laws. Following the law is no more difficult than breaking the law once you are fully informed. Be on the right side of things for the day your bar or restaurant is one of the 11% being audited by the IRS, and avoid an employee complaint that could cost you tens of thousands of dollars in back wage payments. The small expense of consulting a labor attorney is going to be much less costly than if you lose your business breaking the law. Ignorance of the law is not an excuse in court.
If you follow the guidance above, you are well on your way to avoiding conflict with the IRS or DOL. If you are en employer, don’t risk your livelihood. If you are an employee, don’t tolerate an invalid scheme that is taking too much of your hard earned money. Share this article with your employer and help them fix the problems.
Recent changes (Dec. 22, 2020):
The US Department of Labor officially decided to change the FLSA rules for tip pooling on December 22, 2020. The most significant change (along with a lot of discussion and explanation) says that when an employer does not claim a tip credit, they are excused from the “traditional” tip pool regulations. This allows such employers to create mandatory “nontraditional” tip pools that benefit workers who are not usually tipped such as cooks and dishwashers.
In adjacent parts of the rule it was clarified that an employee’s tips can never be kept by a manager, supervisor, or employer even if the employer does not claim a tip credit. It also clarified the definitions of manager and supervisor. It further clarified that managers and supervisors could retain tips directly given by customers for service that they directly provide. Plus the rule now clearly states the monetary penalty for violations of this section.
In general, all tips must be distributed at least as often as payroll. In nontraditional tip pools, the employer must now keep the same kind of records of employee tip amounts and transfers as do employers who claim a tip credit (i.e., IRS form 4070).
The other change in rules (related to the tipped wage) had to do with clarifying the minimum rate of required pay for what the hospitality industry refers to as “side work.” First, the duties must be related to the employee’s tipped occupation; second, the employee must perform the related duties contemporaneously with the tip-producing activities or within a reasonable time immediately before or after the tipped activities. There is no longer a 20% maximum guideline for the amount of side work for which an employee would be paid the sub-minimum wage (when an employer claims a tip credit). Any duty listed as “related” can be at the lower wage rate if it meets the two criteria above, no matter what portion of the shift or week it takes. For a list of related duties, employers and employees should refer to the list of tasks for that occupation in O*NET. There you can find whether duties like cleaning bathrooms versus making toast are considered “related duties” or not.