When is a Tip Subject to Sales and Use Tax?

10 Sep

Restaurants that are maintaining records consistent with guidance issued in IRS Ruling 2012-18 will be presumed to be correctly reporting taxable mandatory service charges to the BOE when regulatory amendments adopted by the BOE are finalized.1

The Ruling provides information on the difference between optional tips (which are not subject to sales tax) and mandatory service charges (which are subject to sales tax) and states that the absence of any of the four following factors indicates that the payment from a customer is a taxable service charge:

  1. The payment must be made free from compulsion;
  2. The customer must have the unrestricted right to determine the amount;
  3. The payment should not be the subject of negotiation or dictated by employer policy; and
  4. Generally, the customer has the right to determine who receives the payment.
Example: Sloppy Joe’s Restaurant does not keep adequate records for purposes of the IRS reporting requirements. Its menu contains the following statement:“For parties of 10 or more, a suggested gratuity of 15% will be included on the bill.”

Guest Check
15 hamburgers $150
10 fries $50
Drinks $45
Subtotal $245
8% sales tax $19.60
Subtotal $264.60
Tip $39.69
Total $304.29

In this case, the tip is a taxable service charge.

Example: A restaurant check is presented to the customer with options computed by the restaurant and presented to the customer as tip suggestions. The “tip” area is blank so the customer may voluntarily write in the amount:

Guest Check
Food Item A $17.00
Beverage Item B $3.00
Subtotal $20.00
8% sales tax $1.60
Subtotal $21.60
Tip* __________ Total __________ * Suggested tips: 15%=$2.06; 18%=$2.47; 20%=$2.74

This is a nontaxable tip.

The regulatory amendments establishing this new bright-line presumption was adopted by the BOE at their August 5, 2014, meeting.2

If approved by the Office of Administrative Law, the changes will apply to sales made on or after January 1, 2015.​