The “One Big Beautiful Bill” (H.R.1) introduced a significant federal tax deduction for tip income that’s likely to affect millions of service workers and their employers. But does this really mean there’s actually ‘no tax on tips’ going forward for employees who receive them? And what does this mean for businesses with staffers who earn tips?
What you’ll learn
What you’ll learn
Updated: August 16, 2025
This article is authored by OnPay, a top-rated payroll provider for small businesses with more than 30 years of experience in payroll, taxes, and small business compliance.
Key takeaways
- Despite headlines claiming “no tax on tips,” there is actually a federal income tax deduction of up to $25,000 that employees can claim when filing their taxes to reduce tip income
- The deduction only applies to tips that are properly reported to employers and appear on Form W-2s — unreported cash tips don’t qualify for this benefit
- Businesses continue withholding federal income tax on all tip income and maintaining normal payroll tax obligations, but may need to update reporting procedures to help employees claim the deduction
- This above-the-line deduction runs from 2025-2028 and phases out for higher earners, targeting middle and lower-income service workers in qualifying tip-earning occupations
This temporary (unless extended by Congress) but impactful change allows eligible employees to reduce their year-end federal income tax liability by up to $25,000 annually for tax years 2025–2028.
For employers managing tipped workers, understanding this deduction makes good business sense for maintaining compliance while supporting your employees’ ability to claim these benefits. In this guide, we cover what you need to know about how the “no tax on tips” deduction works, what it means for those on your payroll, and what it means for your business
The no tax on tips deduction: What changed
The new federal income tax deduction allows employees in tip-earning occupations to claim a deduction for federal income tax withheld from tip income when they file their taxes. This “above-the-line” deduction is available even to workers who take the standard deduction, making it accessible to virtually all eligible tipped employees.
This means that if you have employees who receive tips – think restaurants, salons, delivery drivers – they can now take an above-the-line deduction on their Form 1040 to offset their tip income. The deduction is up to $25,000, which can save them a significant amount on taxes.
Now, here’s the important part – this only applies to tips that are properly reported and show up on the employee’s W-2. Workers should keep in mind that this deduction does not apply to unreported cash tips.
Here’s why this matters for your employees: because it’s an above-the-line deduction, it lowers their adjusted gross income (or AGI), which not only lowers their taxable income, but it can also help them qualify for loans, receive other tax benefits, or qualify for income-based programs.
Key features
- Maximum deduction: Up to $25,000 per individual annually
- Effective period: Tax years 2025 through 2028
- Deduction type: Above-the-line federal income tax deduction
- Retroactive application: Applies to qualified tip income received starting January 1, 2025
Now that we better understand the details of this deduction, let’s find out who is eligible to take advantage of it.
Who qualifies for this deduction
The deduction applies to workers in occupations that typically receive gratuities during the course of the work they perform. Individuals in tip-earning roles can include people from all walks of life, from restaurant servers and bartenders, to nail technicians and salon workers, to hotel and hospitality staff, to coffee shop cashiers and baristas, to valet drivers, and more.
Eligibility requirements
- Must work in a qualifying tip-earning occupation
- Must have a valid Social Security number
- Tips must be reported to the employer and reflected on Form W-2 (or applicable 1099s)
- Income phase-out begins at $150,000 adjusted gross income ($300,000 for joint filers)
Income phase-out details
For every $1,000 of income above the threshold, the deduction is reduced by $100. This phaseout window allows the ‘No Tax on Tips’ deduction to be targeted toward middle and lower-income workers, and not high earners.
What qualifies as tip Income
Moving on, it’s time to cover what counts as “tip income” for this deduction to make sure we’re on the right track.
Qualifying tip income includes
- Cash tips paid voluntarily by customers
- Tips charged on credit/debit cards
- “Pooled” tips received under tip-sharing arrangements
- Any earnings paid voluntarily in an amount determined by the customer without negotiation
Non-qualifying income
- Automatic gratuities or service charges added to bills
- Tips that aren’t reported to the employer
- Any compensation that isn’t considered voluntary tip income
Keep in mind
“The key term here is ‘voluntarily’. In order for a payment to be considered a tip, it must be 100% voluntary on the part of the giver – no negotiation, no automatic gratuity for parties of a certain size, etc. The customer must freely choose to give the tip without any form of coercion.”
— David Kindness, CPA and OnPay contributor
What tax qualifies for the deduction
The deduction applies specifically to federal income tax withheld on tip income only. This means:
Eligible for deduction
- Federal Income Tax (FIT) withheld from reported tip income
Not eligible for deduction
- Social Security and Medicare taxes
- State and local taxes
- Federal income tax withheld from regular (non-tip) wages
What employers need to know
Tax withholding responsibilities
- Continue normal withholding: Employers must still withhold and remit federal income tax on all tip income
- No impact on employer liability: The deduction doesn’t affect your business’s tax obligations
- Payroll taxes still apply: Despite the phrase ‘no tax on tips’ making lots of headlines before the legislation passed, Social Security and Medicare taxes — 7.65% each for the employer and 7.65% for the employee — continue on all tip earnings
Reporting requirements
Employers will have new reporting obligations to help employees claim this deduction smoothly. Here’s what we know so far.
Form W-2 updates
- Updated forms will include new fields and reporting codes for deductible tip income
- Must report qualified tip income separately from other withholdings
- Required for tax years 2025-2028, with the possibility of extension by Congress after 2028
Special considerations for 2025
- Employers may “approximate” qualified cash tip amounts using a “reasonable method” (to be defined by the Treasury Secretary)
- Must report all qualified tip income retroactively, starting on January 1, 2025
Large food and beverage establishments
- Continue filing Form 8027 (employer’s annual tip reporting form)
- Additional tracking may be needed for the new deduction reporting
System and process updates
- Payroll systems: May need updates to track and report qualified tip income separately
- Recordkeeping: Maintain accurate records of all tip income and related tax withholdings
- Compliance monitoring: Stay alert for additional IRS guidance on implementation
What stays the same
Despite this new deduction, several aspects of tip income taxation remain unchanged.
For employers
- Continue withholding federal income tax on all tip income
- Maintain existing Social Security and Medicare tax obligations
- Keep accurate payroll records and reporting on Form W-2
- File all required forms, including Form 941 and Form 8027 (where applicable)
For employees
- Must continue reporting all tip income to employers
- Pay Social Security and Medicare taxes on all tip earnings
- Follow existing tip reporting procedures and timelines
Compliance watch: What to expect from the IRS
The federal government is expected to provide additional guidance on implementation details, including:
- Specific reporting procedures for qualified tip income
- “Reasonable methods” for approximating 2025 tip amounts
- Updated versions of Form W-2 and related tax forms
- Clarification on qualifying occupations and tip types
Key action items for employers
- Monitor IRS announcements for updated forms and procedures
- Work with payroll providers to ensure system readiness
- Review current tip reporting processes for compliance gaps
- Prepare for potential system updates to track deductible tip income separately
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Long-term planning
While the “no tax on tips” deduction offers immediate financial benefits for tipped workers through 2028, Uncle Sam has presented some changes that employers will want to be aware of. Here’s what to keep up with:
- Accurate recordkeeping: Maintain detailed records of tip income and related tax withholdings
- System preparedness: Ensure payroll systems can handle new reporting requirements
- Ongoing compliance: Stay current with IRS guidance and form updates
- Employee communication: Help your tipped workers understand how to claim the deduction
The temporary nature of this deduction (expiring after 2028) also means employers should prepare for potential changes or extensions as the deadline approaches.
Moving forward
The “no tax on tips” deduction is making waves because it’s a significant change in how tip income is taxed. By understanding these requirements now and being prepared, you can stay ahead of compliance while supporting your employees’ ability to maximize their tax benefits. Stay tuned — we’ll continue to share insights and guidance about the repercussions of this legislation and what it means for small businesses as new information becomes available.
The OnPay editorial team covers payroll, benefits, and HR-related topics to deliver practical insights for growing businesses.