State Board of Equalization:
Restaurant Tips: To What Extent Are They Taxable?

Restaurant tips were at the center of two sales tax appeals heard by the State Board of Equalization during its November 15-16 meetings in Sacramento.

While the term "tip" originated as a 16th century slang term used by criminals for "hand it over," current usage is that it is a reward for service – hence the inaccurate description of "tips" as an acronym for "to insure proper service" or similar phrases (the acronym also is grammatically flawed, as "insure" should be "ensure").

One might conclude that separately stated tips, whether on the customer's bill or not, for non-taxable services are not subject to sales tax. The Board of Equalization has a different view: It believes that mandatory tips are part of the selling price of a meal, and therefore are subject to sales tax (of course, tips also are subject to taxation by the Franchise Tax Board as income to the recipient).

But what are mandatory tips? Logic and the plain meaning of English words suggest that if a customer has a unilateral right to change a suggested tip that a restaurant places on the bill, that does not fall within the plain and customary meaning of "mandatory." However, the BOE, by regulation, has conjured up a different meaning of mandatory: a tip is mandatory if a restaurant places it on the bill, even if it can be changed by the diner.

Board Regulation 1603(g)(2)(c) reads: "It is presumed that an amount added as a tip by the retailer to the bill or invoice presented to the customer is mandatory. A statement on the bill or invoice that the amount added by the retailer is a 'suggested tip,' 'optional gratuity,' or that 'the amount may be increased, decreased, or removed' by the customer does not change the mandatory nature of the charge."

This presumption may be rebutted by documentary evidence showing that the customer specifically requested and authorized that the gratuity be added to the amount billed.

In an appeal before the board with more than $700,000 in sales tax at stake, Olive Garden and Red Lobster Restaurants argued that suggested tips on a bill that could be changed by customers were not mandatory and not subject to tax.

Morrison Foerster attorney Craig Fields, representing the restaurants, presented evidence that the tips are not mandatory. He said the menu for Olive Garden includes the notation, "For your convenience, an optional 18 percent gratuity will be added to parties of 8 or more," and the menu for Red Lobster includes the identical statement, except the percentage is 15 percent. There was no discussion of why the percentage was different at the two restaurant chains.

Mr. Fields then introduced evidence showing that in more than 28 percent of the bills for parties of eight or more, no tip was automatically added to the bill, or the customer changed the suggested tip amount. He said this evidence rebutted the presumption.

Board staff responded that the presumption could not be rebutted by showing that diners changed the tip amount. Although there was disagreement among board staff, a majority of staff voicing an opinion said that even if the suggested tip amounts were changed by 100 percent of the diners, the presumption could not be rebutted.

On one point, taxpayers, board staff and BOE members agreed: the current regulation is not crystal clear.

Concluding that the tips were not mandatory, BOE Member George Runner and Vice Chair Michelle Steel first moved that the appeal be decided in favor of the taxpayer. Mr. Runner said there was a lot of confusion on the interpretation of "rebuttable," and the board created part of the problem. BOE Member Betty Yee opposed the motion, saying the case hinged on what the restaurants intended. The motion was defeated by a 3-2 vote (Ms. Yee, Chairman Jerome Horton and Deputy State Controller Marcy Jo Mandel, representing Controller John Chiang, opposed; Mr. Runner and Ms. Steel in support).

Chairman Horton then suggested that the tips that customers decreased or increased should be fully exempt from tax, but all other tips should be taxable. This motion carried on a 3-2 vote (Aye: Chairman Horton, Mr. Runner and Ms. Mandel; No: Ms. Yee and Ms. Steel). The board also instructed staff to begin work on revisions to the regulation to make it more understandable.

The case was the Appeal of GMRI, Inc.

In another case involving the taxability of restaurant tips, the Appeal of Blowfish LLC, involving sushi restaurants in San Francisco and San Jose, the board sent the matter back for a re-audit.

In dispute was whether the menus used during the audit period said a mandatory tip would be added. The taxpayer said they did not, and the board staff said they had San Francisco menus from the audit period that included a statement that an 18 percent tip would be added to restaurant meals, and a 10 percent tip for take-out. The taxpayer said the prices on the menu submitted were different than the sales prices on the receipts. The taxpayer also said service staff conferred with customers before a tip was manually added.

Board staff said tips were added to cold take-out food, as well as hot take-out food. They said they used Yelp, an online review site, to find out if customers were being charged mandatory tips on take-out orders. Of Yelp's more than 950 reviews of Blowfish Sushi, only three made reference to a mandatory gratuity being charged. One review from a San Francisco customer stated that there is a mandatory 10 percent gratuity on to-go orders. Mr. Runner questioned the strength of the auditor's evidence gleaned from Yelp reviews.

November 18, 2011
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