The New Tip Deduction: What Employers and Business Owners Need to Know

The New Tip Deduction: What Employers and Business Owners Need to Know

Starting with tax year 2025 and continuing through 2028,employees and contractors in certain tipped occupations can deduct up to$25,000 annually per return in voluntarily paid and reported qualified tip income. This deduction is claimed directly on their individual tax returns and is considered “above-the-line,” which means it can be taken even if the taxpayer does not itemize. The deduction is only available to employees and contractors in roles that are “customarily and regularly tipped.” The deduction phases out if modified adjusted gross income is over $150,000 ($300,000 for married taxpayers filing jointly).

Although the deduction for qualified tips is claimed by the recipient of the tips, employers and businesses must meet certain reporting requirements in order for the tip recipient to claim the deduction.

Before we explore the employer’s responsibilities, let’s gain some insight into qualified tips.

Qualified Tips

The tip income deduction is only available for qualified tips. The main elements of a qualified tip are that the tip must be paid in cash and must be voluntary. Additionally, the business must report certain information to the employee or contractor (covered under reporting section of this article) and amounts received in the course of a specified service trade or business (SSTB) are excluded (see SSTB discussion later in this article).

Cash vs Noncash Tips: Qualified tips are amounts received in the form of cash tips. Examples of cash tips, for this purpose, would include payments made with cash, check, credit card, debit card, gift card and most other forms of payment that have a fixed cash value (e.g. casino chips). Tips received under mandatory or voluntary tip sharing agreements(e.g. tip pool) are qualified cash tips as long as they are paid in a cash medium.

Cash tips do not include items paid in any form other than cash (e.g. event tickets, meals, services and most digital assets).

Tips per TRDA or GITCA Program: Recently issued proposed regulations clarify that tips reported pursuant to an agreement under the Tip Rate Determination Agreement (TRDA) or Gaming Industry Tip Compliance Agreement (GITCA) program are eligible for the deduction, provided that the participating employee in the TRDA or GITCA program is otherwise eligible and reports tips using the tip rates established under their agreement. Additionally, the proposed regulations clarify that an employee participating in the TRDA or GITCA program may report additional qualified tips to the IRS on Form 4137.

Voluntary Payments: Amounts charged to customers are qualified tips only if they are paid by customers voluntarily, which means the customer would not be subject to any consequence in the event of nonpayment. When a tip is prompted, for example, on a point-of-sale device or a receipt, the customer must have the option to opt out, or it will not qualify.

Service charges, automatic gratuities or other mandatory charges added to a customer's check, such as for large parties, are not considered qualified tips as they do not constitute voluntary payments. Such charges are non-tip wages and are subject to Social Security tax, Medicare tax, and federal income tax withholding. Factors like compulsion free payments, customer’s unrestricted right to determine the tip amount and who receives the payment should be considered when in doubt about the determinability of tips vs service charges. For example, if a minimum percentage tip is required, the lowest tip percentage required would not qualify but anything the customer chooses to pay beyond that amount would constitute a qualified tip.

To illustrate, let’s say a restaurant bill includes a mandatory charge of 15% on top of the price of the food and beverages consumed. The bill also displays a line below the mandatory charge line giving the customer the option to add an additional amount to the total bill. The 15% charge was paid out of compulsion, and the customer has no choice but to pay it and therefore it is not a qualified tip. The additional amount, if any, that the customer adds to the bill is completely voluntary and, thus, would constitute a qualified tip.

Must Not Be Received in the Course of an SSTB: Tips received in the course of a trade or business that is an SSTB do not form part of qualified tips. Employees of such businesses are also not eligible to deduct tips received from work performed for such businesses.

SSTBs include businesses that perform services in certain fields such as health, law, accounting, actuarial science, consulting, performing arts, athletics, financial services, and brokerage services. SSTBs also include businesses that rely on an individual’s skill and reputation(think celebrities and other public figures) and those involved in certain investment management and securities activities.

Let us unpack what the SSTB restriction means for a W-2employee. SSTB workers (e.g. W-2 employees) working for SSTB businesses are not eligible for tip deduction. For example, singer (SSTB worker) performing in a theatre (SSTB) would be ineligible for the deduction. In contrast, non-SSTB workers are eligible for the deduction. For instance, a theater (SSTB)contracts with a non-SSTB company to provide bartending services during an event. The bartender, as an employee of a non-SSTB company, receives qualified tips and can claim the deduction if otherwise eligible. Another example would be a pianist or a singer who is hired by a hotel to perform in the hotel’s lobby and receives cash tips. Despite engaging in performative arts (an SSTB),the tips qualify since the employer (i.e., the hotel) is not an SSTB.

Must Not Fall Under the Exception List: Amounts received as cash tips from performance of services that are illegal activity, prostitution, pornography, or received by any service provider who holds an ownership stake or is an employee of the payor of the tip, are covered in the exception list and therefore would not constitute qualified tips.

Employer Responsibilities

Now moving to the responsibilities of employers and businessowners, this section will focus on key areas such as recordkeeping, reporting and paying/depositing taxes.

Recordkeeping

Employers should continue to track tips as they have in the past with the potential exception that cash and noncash tips must be tracked separately.

Reporting

The deduction available to the recipient of the tips is only permitted if the tips are properly reported to the individual on an information return provided by the employer (e.g. Form W-2) or other payor (e.g. Form1099-NEC) or reported by the individual on Form 4137, Social Security and Medicare Tax On Unreported Tip Income. Businesses must separately report the specific portion of a tipped individual’s pay that represents cash tips and must identify the individual’s qualifying tip-earning occupation. This level of detail is intended to help the IRS enforce the new deduction rules and verify that only eligible workers are claiming the benefit.

The IRS has released draft versions of the 2026 Form W-2 and Form W-4 which incorporate the new reporting requirements. The 2026 Form W-2changes include two new codes for box 12 to report the amount of cash tips (code TP for employers that are not SSTBs and code TS for those that are) and the expansion of box 14 to report the Treasury Tipped Occupation Code (discussed later in this article).

Note: The IRS has announced that no changes will be made to Form W-2 or 1099 series forms or federal withholding tables for tax year2025 and that employers should continue to use current procedures for reporting and withholding. Despite this announcement, it is still advisable for employers and businesses to provide a statement to employees and contractors containing the relevant information (i.e. amount of cash tips and the applicable Treasury Tipped Occupation Code) in order to assist them with claiming the deduction.

Collecting/depositing and paying federal income taxes/payroll taxes

The $25,000 tip deduction reduces only federal income tax, not Social Security, Medicare, or self-employment taxes. State tax treatment depends on state conformity with the federal code. Further, as discussed above, Form W-2 and 1099 series forms and withholding tables will not be updated for tax year 2025; therefore, employers should continue withholding federal income tax based upon the current withholding tables.

Once the draft version of Form W-4 is finalized for tax year2026, employers should encourage employees in qualified occupations to complete the revised Form W-4 if the employee chooses to modify their withholdings based upon the tip deduction.

Employers are encouraged to review how their current payroll systems track tipped income, overtime wages, and taxable wages and be prepared to implement systems that are enabled to separately track these in isolation to each other and can also identify employees that are in traditionally tipped roles.

Educate your staff about the change and emphasize that tip income is not tax-free income, it’s a deduction they can potentially take on their tax return only if the tips are reported and properly documented and the applicable income thresholds are met.

Treasury Tipped Occupation Code

As mentioned above, employers must report to employees the Treasury Tipped Occupation Code applicable to the employee’s service area(optional, but encouraged, for 2025). The IRS has issued a preliminary list of such codes in the proposed regulations. This list is attached here for your convenience.