Texas mandatory gratuity and sales tax: the 20 percent line

The Texas Comptroller says a mandatory gratuity of 20 percent or less is not subject to sales tax if it is separately and clearly labeled a tip or gratuity on the bill and is distributed only to the employees who regularly provide the service. A mandatory gratuity above 20 percent is taxable, according to the Comptroller's restaurant publication. For a restaurant that adds an automatic charge for large parties, the label, the percentage and the payout all matter.

What does the Comptroller say about tips and gratuities?

The Comptroller's publication on restaurants and food service, Publication 94-117, sets out three points. A voluntary tip is not taxable. A mandatory gratuity of 20 percent or less is not taxable if it is separately and clearly labeled as a tip or gratuity on the bill and distributed only to the employees who regularly provide the service. And, in the page's words, mandatory gratuities exceeding 20 percent are taxable.

The publication is dated March 2014, so confirm the current position with the Comptroller before you build a policy on it. It also does not separately address charges called service charges, so a charge with that label needs a direct question to the Comptroller's tax help team.

Is the whole charge taxable above 20 percent?

The page says gratuities exceeding 20 percent are taxable. It does not spell out whether tax applies to the whole charge or only to the part above 20 percent. Until you have the answer in writing, the cautious choice is to keep any automatic gratuity at or under 20 percent. That keeps the tax question simple.

What does clearly labeled mean?

The line on the check must say tip or gratuity, not fee or service. It must appear separately from the food and drink, not folded into the menu prices. The menu and any reservation confirmation should say when the charge applies, such as parties of eight or more, and the percentage. A charge that is described in one place as a gratuity and in another as a house fee is the kind of inconsistency that makes the tax treatment hard to defend.

Who may receive the money?

The gratuity must be distributed only to employees who regularly provide the service. Servers, bussers and bartenders who worked the table fit. The owner, managers who did not serve the party and back-of-house staff who do not regularly provide table service are outside it on the Comptroller's wording. If you want the kitchen to share, ask the Comptroller or a tax adviser how the payout affects the tax treatment, and read the federal tip pool rules in the tip pooling guide before you decide.

How should you set up the check?

1. Add a gratuity line for parties of a set size and cap it at 20 percent.
2. Calculate it on the food and drink total before tax.
3. Show sales tax on the food and drink only.
4. Pay the gratuity to the serving staff through payroll.
5. Keep the written policy and the payout records.

What about a service charge that the business keeps?

A charge your business keeps, such as a private dining fee or an event fee, is part of the price and is generally taxable. Label it for what it is and charge tax on it. Do not call a retained charge a gratuity.

What about delivery and catering?

The Comptroller's publication does not cover delivery charges. For catering with an automatic gratuity, use the same labeling and payout rules and put the percentage in the written contract. Ask the Comptroller's tax help team in writing about delivery fees and keep the answer.

What should you do before you rely on this?

Read Publication 94-117 on the Comptroller's website, check its date and compare it with any newer guidance. Ask your accountant to review your policy once. A policy that was right for years can become wrong if the rule changes, and the Comptroller assesses tax and interest for the whole audit period.

A worked example for a party of ten

A party of ten orders $400 of food and drink. Your policy adds an 18 percent gratuity for parties of eight or more. The gratuity line is $72, calculated on $400, labeled gratuity and shown apart from the food. Sales tax at 8.25 percent applies to the $400 only, which is $33, so the total is $505. The $72 goes to the servers and bussers who worked the table, through payroll. If the same policy were 22 percent, the Comptroller's wording puts the charge over the line, and you would ask whether tax applies to all of it. That single question is why a 20 percent cap is easy to defend, and why an owner might set the charge at or below it.

How should you train servers to explain it?

Give servers one sentence: an 18 percent gratuity is added for parties of eight or more, and it goes to the team that looks after your table. Tell them what to do when a guest wants to leave more, which is to add a tip on top. Tell them what to do when a guest objects: call a manager, who can explain the policy that was on the menu and the confirmation. Record any adjustments, so you can see whether the policy is working.

More guides for your business:

• Texas tip pooling and service charges for restaurants
• Texas comped meals, coupons and takeout: how sales tax works
• Texas local sales tax rates for restaurants in Houston, Dallas and Austin

More in the US guides for food businesses.