No tax on tips was quite the headline when it was mentioned in the One Big Beautiful Bill Act (OBBBA), and rightfully so! A new tax deduction for service workers is welcome news. But there is more to it: how is it defined, who qualifies, and how do you claim it? Here is what both employees and employers need to know.
How Do They Define ‘No Tax On Tips”?
The IRS says: ” Effective for 2025 through 2028, employees and self-employed individuals may deduct qualified tips received in occupations that are listed by the IRS as customarily and regularly receiving tips on or before December 31, 2024, and that are reported on a Form W-2, Form 1099, or other specified statement furnished to the individual or reported directly by the individual on Form 4137.”
The IRS further defines “Qualified tips are voluntary cash or charged tips received from customers or through tip sharing.”
Note that they specifically mention “voluntary”. This would suggest involuntary tips (i.e. tips automatically added to a bill) need to be separated and will be taxed as ordinary income. However, more guidance is needed to confirm this and how to report them separately.
Is There A Limit?
Yes. The IRS is limiting the maximum annual deduction to $25,000 for employees. The deduction for self-employed individuals may not exceed their net income from the trade or business in which the tips were earned. There is also a phase-out when a taxpayer’s modified adjusted gross income exceeds $150,000 Single/$300,000 Married Filing Jointly.
For your consideration: Could this be a tip trap? Someone who suddenly claims the maximum $25,000 tip deduction, having only reported a small amount of tips in the past, may raise a red flag.
Is There A Catch?
Not a catch, per se, but the national headline ‘No Tax On Tips’ is misleading. It is more accurately stated as ‘No Federal Income Tax on Tips’. Those tips to be reported are still subject to FICA and state income taxes. So don’t think it’s free money – save some for those taxes.
Who Qualifies?
The IRS must publish a list of occupations by October 2, 2025 that customarily and regularly received tips in the past. The intention here seems to be preventing manipulation (i.e. offering a customer a huge discount with an unwritten agreement they’ll give you an equally huge tip in an occupation that previously never received tips won’t fly).
Leak: Axios has published an article claiming to have received the list of occupations ahead of time. You can check it out here.
Self-employed individuals operating a Specified Service Trade or Business (SSTB) under Section 199A do not qualify, nor does anyone filing Married Filing Separately or anyone without a Social Security number.
How Do Employers Report It?
The IRS says they will not change the 2025 Form W-2, and instead “will provide transition relief for tax year 2025 for taxpayers claiming the deduction and for employers and payors subject to the new reporting requirements.” We are awaiting more guidance on what that relief will look like.
For 2026, the IRS has released a draft version of Form W-2 with new code TP to report the total amount of qualified tips, as well as Box 14b for the Treasury tipped occupation code.
How Do Employees Report It?
Based on the information above, employees will not receive a W-2 with their qualified tips until 2026. For 2025, common sense would say document in writing using paystubs, bank statements, and other information to determine your amount of qualified tips. As for where to report it on your 1040, we anticipate the IRS will add a line to Schedule 1 to claim the deduction, but await further guidance.
Haworth & Company Can Help!
If you have questions or need help in your small business, Haworth & Company is here to help! Since 1989 we have been reading tax law and helping small businesses succeed in an ever changing landscape. With three convenient locations in the Twin Cities and a location in Rochester, MN, and a wide range of services including accounting, tax prep, payroll, and consulting, we can be the one-stop-shop trusted advisors your small business needs. Contact us today!
Be sure to check back on our ongoing series discussing the OBBBA and what it means for employers and employees!