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Takeaway
Pending federal legislation is currently moving through Congress that would allow tips to be deducted from federal income taxes. Read our blog post for updates on this legislation and how it might affect employers and employees.
Currently moving through the legislative process is a budget reconciliation bill known as the “One Big Beautiful Bill.” This bill contains a number of significant provisions, one of which would eliminate taxes on tips. Its future is uncertain, and though we can’t give you all the specifics of how it will work, we have lots of information that can help you stay informed about this upcoming change.
It should also be noted that this isn’t the only initiative to address tips and their associated taxes. There is also a freestanding Senate bill that would provide employees with a permanent tax deduction of up $25,000 per year for qualified tips. For this post, we’ll mainly focus on the provision included in the One Big Beautiful Bill.
Read on to learn more about the taxation of tips and how businesses and employees may be impacted.
What are tips and how are they currently taxed?
According to the current IRS definition, “Tips are optional cash or non-cash payments that customers make to employees.” Cash tips include those received directly from customers as cash, but also electronically paid tips and any tips received as part of a tip-sharing arrangement.
Non-cash tips are those received in any medium other than cash, such as tickets, passes or other goods a customer gives the employee.
To determine whether a payment is a tip, the IRS uses a four-factor standard in which all four factors must apply:
- The customer makes the payment free from compulsion.
- The customer has an unrestricted right to choose the amount.
- The payment should not be the subject of negotiations or dictated by employer policy.
- Generally, the customer has the right to determine who receives the payment.
What is the “No Tax on Tips” proposal?
This provision creates an above-the-line deduction on the taxpayer’s tax return for qualified tips received by workers in an occupation which traditionally and customarily receives tips. In order to be considered a qualified tip, the tip amount must be paid voluntarily, must not be subject to negotiation and must be determined by the payor, not the business or the employee. The deduction is allowed for employees receiving a W-2, independent contractors receiving a 1099-K or 1099-NEC, and taxpayers reporting tips on Form 4137.
When will the “No Tax on Tips” law take effect?
If the One Big Beautiful Bill becomes a law, it will apply to taxable years beginning after Dec. 31, 2024. If the bill passes, it will likely be signed into law sometime in 2025. If your employees keep asking “When does No Tax on Tips start?” let them know the answer should be coming soon, but it will probably be retroactive to Jan. 1, 2025.
As it is worded now, the deduction is allowed for tax years 2025 through 2028.
States considering tip tax exemptions
The pending federal bills only deal with federal taxes on tips. The legislation won’t have any effect on state and local rules dealing with tips or overtime. Because each locale has its own laws, it’s important for each employer to understand how they interact with federal legislation.
Who benefits from tax-free tips?
The hospitality industry will likely feel the biggest impact, as a high percentage of hospitality employees receive most of their earnings in tips. This may also take some steam out of efforts to reduce state-level tip credits and initiatives championed by some employers to do away with tipping altogether in favor of service charges or higher prices.
What do tax-free tips mean for employers?
While this proposed legislation that’s included in the One Big Beautiful Bill may have a significant impact on employees, there will also be consequences for employers. That standalone Senate bill will impact employers where applicable.
Tips will still be reported — Employees must report their tips to their employer, and employers will still have to report tips on the employee’s W-2.
Taxes on tips will still be withheld — Because of the way this proposed legislation functions, taxes on tips will be withheld, then subtracted from the total tax liability when eligible employees file their annual returns. This means tips are still subject to federal income tax withholding.
Form W-2 reporting likely won’t change very much — Under the House-approved proposal, employers will need to separately identify total tips reported by employees when they produce the employee’s Form W-2.
Be aware of what aren’t considered tips — Service charges, like 18% gratuities automatically placed on large parties at restaurants, are not tips. Tips that are not reported to the employer may still be deductible if employees use a Form 4137 to report them.
Accounting systems may need to be adjusted — Not every business has a mechanism for specifically recording or tracking income from tips. You may need to reconfigure your system to provide the necessary information to your workforce and appropriate regulators.
There are also staffing forces to consider. With this tax benefit also comes the possibility of an environment where it’s easier to recruit and solve labor shortages in the hospitality industry.
In states that permit it, back-of-house workers like cooks or dishwashers who participate in a tip pool can also benefit. But that isn’t the case in every state. In other states, it may widen the asserted unfairness between servers and back-of-house staff regarding compensation. Hospitality employers may need to review their compensation practices as the favorable tax treatment for tips has the potential to increase the divide between the earnings of tipped and non-tipped workers.
Staying compliant with the new tips tax exemption rules
The specifics of these pending federal bills have yet to be determined, and those specifics will inevitably shape the compliance responsibilities for employees and employers. Even without a detailed breakdown of the mechanisms involved, it’s likely that employers will need to track and report tips as a separate category so these figures can be given to employees for their year-end tax filing.
Ultimately, the compliance responsibilities employers must meet will be determined by the legislation when or if it becomes codified into law.
Frequently asked questions
Are tips currently taxed at the same rate as wages?
For federal purposes, tips are generally treated in the same way as other taxable wages.
What is the tax rate for tips?
The tax rate for tips is the same as other regular earnings.
Will this new rule apply to all industries that accept tips?
Yes, as long as the employee in question is participating in one of the occupations that will be determined by the Treasury Department to be one that customarily receives tips.
Will tips still need to be reported on tax returns?
Yes. Employees will need to report their tips to their employer, and employers will be required to report an employee’s tips on the W-2.
How will this legislation affect my tax refund or liability?
The proposed legislation will reduce your tax liability by an amount equal to the reported tips.
Will cash and credit card tips be treated differently?
No, cash and credit card tips are considered the same under this legislation.
Is the tip tax exemption permanent or temporary?
The current proposal covers tax years 2025 to 2028.
Are service charges considered tips under this law?
Service charges, like an 18% gratuity on a large party at a restaurant, are not considered tips.
How should I track and report my tips going forward?
As necessary, tips should still be reported by employees to their employers. Employers will report recorded tips to their employees via Form W-2, Wage and Tax Statement.
Does this affect state income tax on tips?
The proposed legislation will have no impact on how states tax tips.
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