No Tax on Tips

by Tom Yamachika, President, Tax Foundation Hawaii

When we last discussed the One Big Beautiful Bill Act, we focused on the provision providing no tax on overtime.  This week we focus on no tax on tips.

The provision itself is reasonably straightforward. An individual who receives tips can exclude up to $25,000 of those tips from his or her gross income.

But, of course, there are limitations and qualifications.  First, the individual needs to be working where tipping is regular and customary, such as in a restaurant, bar, hotel, or salon.  Individuals in specified service trades or businesses, such as lawyers, doctors, financial consultants, and accountants, never qualify, even if a customer is moved to give such an individual a tip.

Next, the limitation phases out once the individual reaches a certain amount of Modified Adjusted Gross Income (MAGI).  The threshold amounts are $300,000 for a married couple filing jointly, and $150,000 otherwise.  If the taxpayer’s MAGI exceeds the threshold, then the deduction limit is reduced by $100 for each $1,000 above the income threshold.

As with the no tax on overtime provision, the deduction is taken above the line, which means that the deduction reduces adjusted gross income (AGI thresholds are used to eliminate or reduce other tax benefits), and it can be taken even if the taxpayer does not itemize deductions.

Then, also similar to the no tax on overtime provision, the deduction is temporary.  It is effective this year through 2028, which is the year of the next Presidential election.

Employers of tipped employees will face is how to figure out how much qualified tips each employee earns.  That amount will have to be reported on the employee’s Form W-2.  But, of course, some customers leave cash tips, some leave credit card tips, some tips are pooled and shared among staff, and some “tips” don’t qualify because they are compulsory (an added 15% for large groups, for example).  Compiling all of that data might be challenging.

In addition, there is the possibility that an employee will receive tips and the employer will not know about them.  The employee is supposed to report such tips to the employer, but if that doesn’t happen the employee can, in theory, report them on IRS Form 4137 and pay applicable Social Security and Medicare taxes.  Tips that are not reported to the government at all won’t qualify for the deduction.

Owners of businesses can receive qualified tips too, for example if a bar owner tends the bar sometimes and receives tips when doing that.  But their deduction is limited to the net income from the business.

Interestingly, the push to adopt this provision came not from groups of bartenders, casino dealers, or wait staff, but from the NRA.  Not the Second Amendment advocates, but the National Restaurant Association.  That association mostly represents restaurant owners rather than hirelings.

Indeed, the staff on the lower end of the totem pole might not see any tax benefit from this provision at all because their income is already so low that given the large standard deduction, which taxpayers get simply by filing a tax return, many of these workers will not have tax liability anyway.  An additional deduction will not turn into a check from the Government; once a taxpayer’s liability is zero, more deductions are meaningless.

Rather, “no tax on tips” may motivate employers to lower base wages and apply pressure on lawmakers to increase the “tip credit,” the difference between what tipped workers can be paid legally and the minimum wage, thereby allowing employers to pay tipped workers a base wage that is even less than what they are required to pay now.