Understanding and guidance on surcharges
Due to a myriad of legislative and court decisions, some restaurants in California have elected to add a surcharge to their receipts to defray increased costs incurred over the last several years.
The increased costs of operating a restaurant can be attributed to minimum wage increases, healthcare, paid sick leave, restrictive scheduling, cost of food and supplies and the current state of the law that does not allow restaurants to mandate tips to employees who do not regularly interact with customers. As such, these surcharges need to be analyzed for taxation purposes and legality as to how they are implemented.
First let us think about how surcharges affect a company from a tax and reporting perspective. Starting in 1994, many restaurants have benefited from being allowed to apply a general business credit toward a portion of the employer’s Social Security and Medicare taxes paid with respect to their employees’ cash tip earnings (IRC 45 B). However, the policy set forth in Rev. Rule 2012-18 means that the credit would not apply with respect to surcharges, because these mandatory charges do not qualify as tips.
On December 23, 2016, the California State Board of Equalization (“BOE”) made it clear that surcharges like a service charge are a taxable event. The BOE states that: “The Revenue and Taxation Code (RTC) provides that sales tax is imposed on the gross receipts from the retail sales of tangible personal property in this state, unless the sale is specifically exempted from taxation by statute. The sales tax is imposed upon the retailer for the privilege of selling tangible personal property at retail in California. RTC section 6012, ‘Gross receipts,’ provides that the taxable gross receipts include all amounts received with respect to the sale, with no deduction for the cost of the property sold, materials used, labor or service cost, or any other expense of the retailer passed on to the customer. As explained by RTC section 6012, any expense of a restaurant passed on to customers in the form of a surcharge must be included in taxable gross receipts. Since there are no specific sales and use tax exemptions for a surcharge imposed by a restaurant, retailers may not claim the cost of the surcharge as a deduction on their Sales and Use Tax return. Therefore, restaurants that include a separate surcharge on customer bills must include the surcharge amount in the calculation of tax.”
In light of this guidance, to the extent a restaurant elects to distribute a surcharge to its employees, the surcharge will be treated and must be reported as Salaries and Wages on the business tax return. Another issue to consider is that an employer who pays out a portion of the surcharges to employees may have to recalculate its employees’ overtime rates (if the employees work more than 40 hours in a week or 8 hours a day for businesses in California). As any distributed surcharges are wages, that money would count toward an employee’s regular rate of pay and therefore must be factored into the overtime rate calculation.
Recently, comments by several City Attorneys like San Diego, as well as some letters, have raised issues concerning surcharges. Specifically, some City Attorneys have raised the manner under which surcharges are communicated to customers. There have been some claims asserted generally citing California Business and Professions Code 17500 et seq., 17200 et seq. and California Civil Code 1770, and the Consumer Legal Remedies Act that some restaurants may be in violation of consumer protection laws prohibiting false advertising. These statements have claimed that a failure to clearly and conspicuously communicate a surcharge might render the stated price of a food item untrue and misleading under California law and could constitute false advertising. Also there have been some statements that such charges are being investigated and may result in prosecution under the guise of consumer protection for false advertising.
As a result, even though surcharges are a legal and allowable option for restaurants to help defray the recent increases in costs, there are some approaches that should be considered to avoid potential litigation. There are no regulations or laws that state how a restaurant should specifically and clearly disclose the existence of a surcharge. However, to try and prevent the filing of an adverse claim, it would be prudent that a restaurant disclose up front that the meal (food item(s)) is subject to a surcharge and state the percentage of the surcharge on the menu, in a prominent sign or posting, on web pages, as well as on advertising materials either electronic or paper. Also even though not required, it would be prudent that the disclosure stand alone and not be contained in a statement about other aspects of the business. Some restaurants have elected to highlight the disclosure in a different or larger font or color as a means to try and alleviate concerns raised by governmental entities. That said, there is no mandatory way that a surcharge should be disclosed to a customer. In summary, there is no legislative or statutory guidance as to how a surcharge should be disclosed.
There is no requirement that a sign be used to disclose a surcharge. If a restaurant were to decide to use signage, there is also no requirement about the size of font on any sign posted in a restaurant about a surcharge. However, if a sign is used, the guidelines set forth under California’s Proposition 65 law about disclosure of potentially hazardous materials might be used as a guidepost. Under Proposition 65, the signs are to be “conspicuous” enough that they are “likely to be read and understood by an ordinary individual under customary conditions of use and purchase.” Therefore, having this as a goal would help a restaurant defend and prevent any legal action. That said, the use of a sign and the size of the sign is nowhere mandated for a surcharge disclosure.
As such, the restaurants who elect to use a sign could consider a sign about a surcharge and percentage where patrons are likely to see it as they enter the restaurant. Like approved signs in Proposition 65 cases, a sign no smaller than 10 inches wide by 10 inches high or a horizontal strip marker no smaller than 10 ½ inches wide by 1 ¼ inches high bearing the surcharge information in at least a 36-point font would arguably comply with the “conspicuous” requirements. Also, if a fair amount of the business is take-out or occurs at a register, the placing of a disclosure sign at the register would likewise be another preventive step to be considered for notice purposes.
As to menus, any statement as to surcharges should be separate from other information. Some restaurants have elected to use bold font, a different color or italics. However, none of this is required. It is merely one option. In addition, the font as to the disclosure should not be smaller than other items printed on menus or electronic media. These steps could help defray any claims that the restaurant did not clearly and conspicuously disclose the existence of a surcharge.
Many San Francisco restaurants implemented a surcharge (i.e., an extra fee or cost) on the goods or services they sell to customers to cover, in whole or in part, the expense of complying with the Health Care Security Ordinance passed in 2008. This surcharge was specifically designated to defray the costs of the local healthcare ordinance. Some restaurants faced litigation and penalties when these surcharges were not utilized to pay for the cost of health care. There is now a requirement in San Francisco that the business on an annual basis disclose: 1) the amount collected from the surcharge for covered employee health care and 2) the amount spent on covered employee health care. Therefore, based on these lessons learned, if a restaurant elects to impose a surcharge, it should consider disclosing it in a broad manner rather than designating it for a particular cost item. A more specific designation could subject a restaurant to show that the surcharge collected must be only used for that item e.g., the cost of health care to employees. As a result, a broad designation of the surcharge would be a good preventive measure.
Overall, surcharges are legal but restaurants should implement with an eye toward prevention of any claims of false advertising, unfair business practices or improper utilization of the surcharge. Also, there is no mandate by California or any California municipality that requires that a surcharge be added to a restaurant bill. Therefore, the restaurant has wide discretion as to how it discloses and communicates the use of a surcharge.
If a restaurant elects to implement a surcharge, at a minimum the fact that there is a surcharge must be disclosed on the receipt as “SURCHARGE” and the restaurant must charge sales tax on all service charges and any separate surcharge line item, regardless of any amount that might be paid to the employee.
Other steps a restaurant might consider but are not currently required or mandated:
- If a sign is utilized, take steps to place the sign at an entrance and/or at check out area, disclosing the surcharge
- The use of the words “mandate” or “mandatory” when describing the surcharge, while not illegal, has been misinterpreted and has been criticized by some customers and political officials.
- Consider disclosing the surcharge on menus, on websites and in advertisements, both paper and electronic, about the prices at a restaurant
- Keep any rationale as to the reason for the surcharge as broad as possible, e.g., to defray the increased cost of operations
Also, it is important to consult with your tax advisor or tax attorney to determine the proper method of taxing surcharges and paying your employees if a portion of the surcharge is distributed to the employees. It is highly recommended to consult with qualified legal counsel concerning any questions about surcharges and how to disclose them to customers.
This report was reviewed for legal accuracy and updated in 2018 by Wilson Elser Moskowitz Edelman & Dicker LLP.