26 Aug How does the new “no tax on tips” law work?
Anita Byer
The One Big Beautiful Bill Act (H.R. 1) is likely to have significant impact on those operating in industries that customarily and regularly involve tipping. The bill’s “no tax on tips” section adds a temporary, retroactive federal income tax deduction for “qualified tips” to the Internal Revenue Code, effective January 1, 2025. Since tips have historically been subject to federal income taxes, the current landscape is expected to change considerably, at least until the deduction expires after the 2028 tax year.
Is the tip deduction unlimited? No. The tip deduction is capped at $25,000 per year, but this amount may be reduced depending on the employee’s income. The cap on tip deductions is reduced (but not below zero) by $100 for each $1,000 by which the taxpayer’s modified adjusted gross income exceeds $150,000 ($300,000 in the case of a joint return).
Does the deduction apply to all tipped employees? No. The tip deduction only applies to employees working in an occupation which customarily and regularly received tips on or before December 31, 2024. The Secretary of the Treasury has until October 2nd to publish the list of occupations that traditionally (i.e., prior to enactment of the tip tax deduction) received tips. Once this highly anticipated list is published, the true breadth and scope of this deduction will be known.
Does the deduction apply to all kinds of tips? No, the deduction only applies to “qualified tips.” To be eligible for the deduction, the tip must be paid voluntarily without any consequence in the event of nonpayment. The tip amount may not be the subject of negotiation and must be determined by the payor (customer). Qualified tips include tips received from customers that are paid in cash or charged, and, in the case of an employee, tips received under any tip-sharing agreement. This means that mandatory service charges and required gratuities (e.g., large parties) would not be considered qualified tips eligible for the tax deduction.
Do tipped employees have to report their tips? Yes. According to the Internal Revenue Service, to be eligible for the deduction, the tips must be reported on a Form W-2, Form 1099, or other specified statement furnished to the taxpayer or reported directly by the taxpayer on Form 4137 (Social Security and Medicare Tax on Unreported Tip Income).
Does the deduction apply to married individuals? Yes, but only if the tipped employee and his or her spouse file a joint return for the taxable year.
The tip tax deduction is available regardless of whether the tipped employee itemizes deductions, so it can be claimed in addition to the standard deduction for individuals. Individuals taking the tip tax deduction must include their social security number on their tax return. In addition to the list of qualifying occupations, the Secretary of the Treasury is required to issue regulations and other guidance as may be necessary to prevent reclassification of income as qualified tips, including regulations or other guidance to prevent abuse of the deduction allowed by this section.
The current uncertainty surrounding the new tip tax deduction can result in unintentional violations. To protect against potentially significant liability exposures, employers should consider purchasing an Employment Practices Liability Insurance that includes limited wage & hour coverage. Please contact us if you would like to learn more about employment practices liability insurance.