Introduced by Congressman Earl Blumenauer (D-OR) on May 15, 2024, the Restaurant Service Charge Tax Fairness Act seeks to provide critical support to independent restaurants and bars by addressing the growing adoption of service charges as a compensation model. Historically, the restaurant industry has operated under a tipping system, where customer-facing staff like servers and bartenders receive tips on top of their hourly wages. This system, however, creates a significant pay disparity between front-of-house employees who receive tips and back-of-house staff like chefs, dishwashers, and line cooks, who rely solely on a fixed hourly wage.

In response to changing workforce expectations and post-pandemic labor challenges, many restaurants have begun implementing service charges—typically ranging from 15-23%—that are applied directly to customer checks. Unlike tips, which are discretionary, service charges are mandatory fees designed to create a more equitable and stable wage distribution among both front- and back-of-house employees. However, the current tax code penalizes restaurants that adopt this model by treating service charges as regular income subject to full taxation, unlike tips, which are passed through without being taxed.

The Restaurant Service Charge Tax Fairness Act aims to address this disparity by ensuring that service charges are treated more like tips under the tax code, making it easier for independent restaurants and bars to adapt their business models in ways that promote equity, stability, and fairness.

 Key Tenets of the Restaurant Service Charge Tax Fairness Act

• Tax Treatment Alignment: The Act proposes that service charges be excluded from FICA taxes, aligning their tax treatment with traditional tips. This would relieve restaurants of the financial burden associated with the current system, where service charges are taxed as regular revenue, ensuring a fairer distribution of income and benefits for employees.
• Direct Distribution: To ensure fairness, the Act would mandate that service charges be passed directly to non-management employees in the form of wages. This provision guarantees that service charge revenue benefits the workforce, promoting equity across all roles in the restaurant.
• Cap on Exclusion: The Act proposes capping the exclusion of service charges from FICA taxes at 25% to prevent abuse of the system while maintaining fiscal responsibility. This limitation is designed to strike a balance between incentivizing the service charge model and ensuring the integrity of the tax system.
• Overtime Exemption: The Act includes a provision that would exclude service charges from the calculation of wages for overtime purposes, thereby preventing the double taxation of service charge income.

 Why the Restaurant Service Charge Tax Fairness Act Matters

• Equitable Compensation: By adopting a service charge model, restaurants can provide more equitable compensation to all staff, ensuring that pay is not reliant on factors such as customer satisfaction or implicit biases that may impact tipping behavior. It also promotes wage stability for employees, particularly in an industry where income can be unpredictable.
• Supporting Small Businesses: Independent restaurants often operate with slim profit margins and face challenges in offering comprehensive benefits like health insurance to their employees. The service charge model provides a viable alternative that enables restaurants to better compensate their staff while offering greater financial predictability. However, under current tax regulations, businesses adopting this model are penalized, putting undue strain on their operations.
• Modernizing Tax Policy: The Act represents an important step toward modernizing the tax code to reflect the evolving dynamics of the restaurant industry. As more restaurants explore alternative compensation models in the face of labor shortages and post-pandemic recovery, the Service Charge Tax Fairness Act provides the flexibility needed to adapt and thrive.

Frequently Asked Questions (FAQs)

Would this legislation impact industries other than restaurants, like hotels?  

No, this provision is specifically designed for food and beverage service establishments. The section of the tax code that would be amended only applies to tips and service charges on food and beverages.

How are service charges different from "junk fees" seen in other industries?  

Service charges in restaurants are typically transparent, with clear disclosures on menus or customer checks. The Act caps the percentage of service charges eligible for the tax credit at 25%, ensuring that these charges remain reasonable and are directed toward employee compensation, unlike "junk fees" in other industries that may lack transparency.

Will restaurants be required to switch to a service charge model?  

No. The use of a service charge model is entirely optional. Restaurants that wish to maintain a tipping system can continue to do so without any penalties or changes to their current tax treatment.

Can a restaurant use both a service charge and tips?  

No, under the proposed legislation, restaurants must choose between the service charge credit or the traditional tip credit, but they cannot use both simultaneously.

Will this legislation change the IRS definitions of tips?  

No, the Act does not alter the IRS's current definitions of tips.

How can you guarantee that service charges will go to employees?  

The Act stipulates that in order for a restaurant to take advantage of the service charge tax credit, the charges must be distributed directly to non-management employees. Failure to do so would disqualify the business from receiving the tax benefit.

What impact will this legislation have on federal revenue?  

The impact on federal revenue is expected to be minimal. Restaurants that switch to the service charge model will forfeit their tip credit, making the overall fiscal effect de minimis.