In the restaurant industry, it is common for businesses to post a menu notation requiring a certain percentage mandatory gratuity due from large parties. This is the restaurants’ way of protecting its serving staff from being under-tipped. According to the California State Board of Equalization, if a business adds a preset or mandatory tip when serving a large group, this tip is considered a service charge, and thus subject to sales tax. These mandatory tips should be reported as taxable sales, and sales tax is due even if it was not charged to the customer.
Mandatory tips or service charges are also relevant to catering. When a business adds a tip, gratuity or service charge to a catering contract, these charges are subject to sales tax. If the customer then voluntarily decides to tip over the preset amount, the voluntary portion of the tip is not subject to sales tax.
When tips, gratuities or service charges are optional or voluntary and paid to the employees, they are not subject to tax. A few examples of optional or voluntary tips include:
1.) As in the case of a catering contract, a voluntary tip above a preset amount made in the normal course of business is not subject to tax.
2.) If a customer is presented the check with the tip area left blank for a voluntary tip amount to be decided upon by the customer, the tip is not subject to tax.
3.) If a customer is presented with a check offering suggested tip amounts, perhaps 15%, 18% and 20% calculations, as long as the check has a blank tip area where the customer could write in the tip amount, the tip is not subject to tax.
In order to avoid taxation on tips, it is important that businesses do not add a preset amount to a customer’s bill or catering contract. This makes the tip mandatory, and thus subject to tax. In addition, it would be our recommendation that any notation printed on menus or other signage requiring a mandatory tip be eliminated. This will help avoid any type of mandatory tip being required by customers, and thus subject to tax.
In addition to sales tax issues, mandatory tips also create problems for the Tip Credit calculation (45B Credit). Many restaurants have benefitted from this general business credit based on an employer’s Social Security and Medicare taxes paid with respect to the employees’ tip earnings. According to Rev. Rule 2012-18, payroll taxes associated with mandatory tips do not generate a tip credit. For further information regarding the taxation of tips, please reference our blog post, dated September 12, 2012, titled Tax Bulletin: Guidance on Tips and Service Charges.