Is There a California Sales Tax on Restaurant Tips?

It’s an interesting question as to whether the California Department of Fee and Tax Administration (CDFTA) (formerly known as the State Board of Equalization or BOE, or SBE) requires business to collect sales tax on tips. Generally, under California Sales and Use Tax Law, retailers must collect Sales Tax on the sale of tangible personal property within the State of California. California Revenue and Taxation Code Section 6051.

A tip hardly sounds like tangible property. Nevertheless, the CDTFA has issued regulations which provide that tips are subject to Sales Tax in certain situations. A case decided by the California Court of Appeals (not to be confused with the California Supreme Court) upheld those regulations in a case decided on March 9, 2018. It will be interesting to see if there is a further appeal.

Under the CDTFA regulations, tips that are added by customers, which are optional, are not subject to Sales Tax. On the other hand, so called mandatory payments are subject to Sales Tax. The situation that is generally subject to Sales Tax occurs where a restaurant adds a gratuity to the bill, usually for parties over a certain size.

GMRI, Inc v. California Department of Tax and Fee Administration, which upheld the Department’s regulations, presented an interesting fact pattern. GMRI operated Olive Garden and Red Lobster restaurants. Apparently GMRI, Inc. also owns and operates a network of fresh grill and wine bars in the United States including Seasons 52.

The restaurants at issue in the current case added an “optional” gratuity of 15 to 18% to the bill of large parties. The patrons could by request either modify the gratuity or have it taken off the bill entirely. Despite these facts, the Court of Appeal held that under the literal language of the CDTFA regulations the gratuity was a mandatory payment. The Court was not moved by the fact that 100% of the gratuity was paid to the servers. Instead it quoted the regulation which states:

A tip, gratuity, or service charge is optional if the customer adds the amount to the bill presented by the retailer, or otherwise leaves a separate amount in payment over and above the actual amount due the retailer for the sale of meals, food, and drinks that include services.

GMRI argued that the regulation was in violation of the law passed by the California legislature and was illogical. The judge held that it was not up to the Court to determine the “wisdom” of the regulation, but merely its legality. GMRI pointed out that under the California Labor Code the gratuity was the “sole property” of the server. The Court was likewise unmoved by this argument.

It seems that this leave restaurateurs with a difficult problem. Who will bear the cost of the Sales Tax imposed on large party gratuities? Will it be the restaurant, the customer, or the server? We here are Brager Tax Law Group practice only Tax Law, however, it seems that the Labor Code would prevent the restaurant from reducing the amount of the employee tip by the Sales Tax it has to pay. Alternatively, the customer can pay Sales Tax on the gratuity. This would probably not sit well with most customers. Nevertheless, restaurant profit margins are thin already and most restaurants wouldn’t want their profits reduced further. The best solution may be NOT to charge a large party gratuity, and let the servers remind their customers that a tip is highly appreciated.