No Tax on Tips: How Is Payroll Affected?

Overview of tipped income and current tax rules

Tipped income in the United States has long been subject to specific rules under the Internal Revenue Code and IRS regulations. Understanding the baseline rules helps frame how recent changes affect payroll.

What is tipped income?

Tipped income refers to amounts received by an employee (or in some cases, self-employed individual) from customers for services, over and above the regular wage or salary. Examples include restaurant servers, bartenders, hair stylists, salon staff, hotel porters, and others in “tip‐customary” occupations.

Tax treatment under prior law

Under longstanding IRS guidance, all tips received (cash, charged, and through tip-sharing or pooling) are taxable income and must be included in gross income. IRS+3IRS+3Congress.gov+3
For payroll tax (Social Security and Medicare), the employee’s and employer’s obligations generally apply: tips are subject to FICA, and the employer must withhold and pay as required. Congress.gov+2IRS+2
For income tax, tipped income is included in taxable income and taxed under ordinary income tax rules. Congress.gov+1
Reporting requirements: For example, if an employee receives $20 or more in tips in a calendar month from one employer, that employee must report the amount to the employer by the 10th day of the following month. IRS+1
Non-cash tips (e.g., tickets, passes, gifts) are also taxable and must be included in gross income at fair market value. IRS

Payroll implications under prior law

From a payroll perspective, for employees receiving tips:

The employer must include reported tips in wages for purposes of FICA withholding and employer/employee payroll tax responsibilities. Congress.gov+1
The employer must also ensure proper wage reporting to IRS/SSA (e.g., via Form W-2), including tip income.
Employees must keep tip records and report monthly to the employer, where applicable. IRS+1
For payroll planning, since tips are treated as wages, they affect taxable wages, overtime rules, unemployment tax, and other wage‐based reporting.

With that baseline in mind, let’s turn to the new change: the “No Tax on Tips” provision.

2) What are the “no tax on tips” changes?

In mid-2025, the U.S. Congress passed, and the President signed, legislation creating a new deduction for certain tipped workers. Here’s what payroll and accounting professionals should know.

Legislative background

The bill commonly referred to as the No Tax on Tips Act (S. 129) was introduced in the 119th Congress. Congress.gov+1
The new provision is included in the larger omnibus tax and spending measure known as the One, Big, Beautiful Bill Act (OBBBA) signed into law on July 4, 2025. IRS+2IRS+2

Key features of the “No Tax on Tips” provision

Effective for tax years beginning on or after January 1, 2025 (so employees will first claim the benefit when filing tax returns for 2025, in early 2026). Kiplinger
The law establishes an above-the-line federal income tax deduction (not a credit) for “qualified tips” earned in eligible occupations. IRS+1
The maximum deduction is $25,000 per year for employees (for self-employed individuals, the deduction cannot exceed the net income from the trade or business in which the tips were earned). IRS+1
There is a phase-out beginning at modified adjusted gross income (MAGI) of $150,000 for single filers ($300,000 for joint filers). IRS+1
The deduction is available whether or not the taxpayer itemizes deductions (i.e., both itemizers and non‐itemizers can claim it). IRS
Importantly, this deduction applies to federal income tax only. It does not exempt the tipped income from payroll taxes (Social Security, Medicare) or from state or local income taxes (unless a state separately enacts its own exemption). Kiplinger+1
The law is currently temporary: it applies for tax years 2025 through 2028. Littler Mendelson P.C.+1

Why it matters for payroll

While employees will claim the deduction on their tax returns, the payroll function must remain aware of how tipped income is reported and the impact on withholding, especially when employees anticipate the deduction and may adjust their Form W-4. Patriot Software
Employers must maintain accurate tip reporting, because the deduction relies on properly reported tips and reporting of the occupation class of the tipped worker. Littler Mendelson P.C.+1
Payroll systems may need to accommodate new codes, boxes and fields in future reporting (see Section 6).

In short: this change does not immediately alter withholding or employer payroll tax treatment of tips, but it adds a layer of tax deduction eligibility for certain tipped workers and thus affects payroll administration and planning.

3) What type of occupations qualify for the tip tax deduction?

A key question for employers and payroll departments is: which occupations qualify under the new “no tax on tips” deduction?

Qualifying “tip-customary” occupations

Under the statute and IRS/Treasury guidance, the deduction applies to individuals (employees or self-employed) who earned qualified tips in occupations that are listed by the Secretary (Treasury) as those that “customarily and regularly” received tips on or before December 31, 2024. IRS+1
The guidance indicates this includes occupations such as servers, bartenders, hairdressers, nail technicians, etc., though the exact list of occupations is to be published. Patriot Software+1

What counts as “qualified tips”?

The law defines “qualified tips” to include:

Voluntary cash tips (including through tip sharing/pooling) received from customers. IRS
Tips that are reported on Form W-2, Form 1099 (as applicable), or otherwise reported via IRS specified statements (for self-employed). IRS+1
The tip must be earned in the course of employment in a qualifying tipped occupation. Congress.gov+1

Additional considerations

The deduction is available whether or not the employee itemizes deductions. IRS
Self-employed individuals may use the deduction, but only up to the net income of the business from that trade. IRS+1
Employers must report the occupation of the tipped employee and provide information returns for tips, to allow the deduction to be claimed. Littler Mendelson P.C.

Example occupations (preliminary list)

While the official list is still being finalized, media and commentary sources suggest the list may include occupations such as restaurant servers, bartenders, hotel housekeepers, hair stylists, nail techs, massage therapists etc. The Times of India+1

Payroll professionals should monitor the IRS/Treasury expected October 2025 publication of the occupation list. IRS

4) What tipped employees don’t qualify under the new tax deduction?

It’s equally important to understand who and what is not eligible under the “no tax on tips” deduction.

Non-qualifying situations

If the occupation is not on the Treasury/IRS list of occupations that “customarily and regularly” received tips on or before December 31, 2024, the deduction is not available. IRS+1
Tips that are mandatory service charges, auto-gratuities imposed by the employer, or fees that are effectively wages rather than voluntary tips generally do not qualify. Commentary emphasizes the deduction applies to voluntary tips. National Association of Home Builders+1
Tipped workers whose employer is in a “Specified Service Trade or Business” (SSTB) under section 199A (for self-employed individuals) may be excluded. The law disallows the deduction for self-employed in SSTBs and employees whose employer is SSTB. IRS
Employees whose income exceeds the phase-out thresholds (MAGI above $150,000 single / $300,000 joint) may see the deduction reduced or eliminated. IRS+1
State and local tax treatment: Even if federal deduction applies, state income tax laws may still tax the tip income unless that state specifically provides otherwise. Thus, for state payroll/tax reporting, tips remain taxable under many state jurisdictions. Kiplinger

Practical payroll implications

Employers whose workforce includes employees in ambiguous roles (for example, hybrid service/wage roles) should review whether the occupation is likely to qualify.
Employee tip reporting/recordkeeping remains critical—since the deduction hinges on properly reported tip amounts.
For employees who anticipate the deduction, they may adjust Form W-4 withholding, but employers must ensure proper withholding based on the usual wage/tip rules. (See next section.)

In short: the deduction is not a blanket “tips are tax-free” rule—eligibility and correct classification matter significantly.

5) How should employers handle the “no tax on tips” in payroll?

From a payroll operations standpoint, the “no tax on tips” change introduces some important considerations—though it does not immediately change how tips are treated for payroll tax withholding.

Withholding and reporting in 2025

For tax year 2025 (first year of eligibility), employers should continue to withhold and report tip income in the same manner as before: treat tips as wages, with applicable Social Security and Medicare tax withholding, and include tip income on the employee’s Form W-2. Patriot Software+1
Employers should not reduce withholding solely because an employee may claim the deduction of up to $25,000, because the deduction is claimed on the employee’s tax return—not at the time of payroll withholding. Patriot Software
Employers should ensure accurate tip records and reporting—for example, recording occupation codes (once published), tip amounts, and reporting to IRS/SSA as required. Commentary notes that employers must file information returns and furnish statements to taxpayers showing certain cash tips and occupation. IRS+1

Payroll system and operational adjustments

Employers should monitor IRS/SSA guidance and ensure that systems can accommodate any new codes or fields for tip occupations, tip deduction eligibility, etc. Advisory materials suggest anticipating changes to Form W-2 and W-4 (more on that shortly). Patriot Software
Employers may consider educating tipped employees about the deduction opportunity—and how their tip reporting and W-4 withholding interact with it. For example, employees who anticipate qualifying for the deduction may choose to adjust withholding accordingly—but employers must ensure compliance with existing rules.
Tip pooling or sharing arrangements: Employers should review tip pool policies and ensure compliance with federal fair labor standards and IRS guidance. Since the deduction could incent increased reliance on tips, employers should ensure tip pooling/sharing rules are enforced to avoid abuse. Littler Mendelson P.C.

Key takeaways for payroll professionals

Do not stop withholding or change payroll tax computations for tips solely because of the new deduction.
Maintain accurate tip reporting, documentation and occupation classification.
Prepare for future reporting changes (new codes, W-2 boxes, W-4 adjustments).
Communicate clearly with tipped employees about what the deduction means—and what it doesn’t mean (for example, payroll taxes still apply).
Stay updated for regulatory guidance from IRS/Treasury (e.g., list of qualifying occupations, implementation instructions).

By addressing the payroll side proactively, employers and payroll teams reduce risk and help employees correctly take advantage of the new deduction.

6) Changes coming to the 2026 Form W-2

Because the deduction is being implemented starting tax year 2025, with first filings in 2026, changes to reporting forms are expected. Payroll teams should be aware of pending changes to Form W-2 and related forms.

Reporting changes anticipated

Draft guidance (and payroll-industry commentary) indicates that for the 2026 tax year (Forms W-2 issued in January 2027) there will be new codes in Box 12 (e.g., code “TP” for qualified tips) and possibly other codes (code “TT” for qualified overtime) to help track eligible amounts. Patriot Software
Box 14 may be updated to include a “tipped occupation code” (Box 14b) so that the IRS can match tipped deduction eligibility with occupation classification. Patriot Software
Employers should expect updated instructions for Form W-4 for 2026, where employees estimate tip income and other specified amounts that may affect withholding—so payroll systems need to be ready to accept the new W-4 information. Patriot Software
The transition year (2025) is considered a “relief year” for reporting, meaning that while 2025 tip deduction eligibility exists, the full detailed reporting infrastructure may not be in place. Employers should monitor for transitional guidance. IRS+1

Impact on payroll timing

Employers should update form templates and payroll software early in 2026 to include new boxes and codes.
Payroll teams should test data systems and reporting workflows to ensure correct capture of tipped occupation codes, tip amounts, and any new fields for deduction eligibility.
Payroll training and documentation should be updated so that payroll staff know how to capture tip data and integrate with year-end reporting.

Summary for payroll teams

Prepare now for 2026 reporting changes, even though the new deduction applies for 2025 tax year. The change is likely to require coordination among payroll, HR, tax, and finance departments.

7) “No tax on tips” FAQs

Here are some frequently-asked questions (and answers) about the “no tax on tips” deduction, tailored for payroll and accounting professionals.

Q: Does “no tax on tips” mean no federal taxes on tips at all?
A: No—not exactly. The deduction means eligible employees (and some self-employed individuals) may deduct up to $25,000 of qualified tips from their federal income tax liability. However, tips are still subject to payroll taxes (Social Security and Medicare) and may be subject to state/local income tax. Ogletree+1

Q: When does the deduction apply?
A: It applies for tax years beginning January 1, 2025 onward (so first claims will be on 2025 returns filed in 2026). The deduction is set to expire after tax year 2028 (unless extended by legislation). Littler Mendelson P.C.

Q: How much is the deduction?
A: Up to $25,000 per year for eligible employees. For self-employed individuals, the amount cannot exceed their net income from the business in which the tips were earned. IRS+1

Q: Who qualifies?
A: Employees (and eligible self‐employed individuals) in occupations that the Treasury/IRS lists as “customarily and regularly” receiving tips on or before December 31, 2024. Tips must be reported (via W-2, 1099, Form 4137 for certain tip income) and must be voluntary. The taxpayer must also meet other criteria (e.g., Social Security number, joint filing rules). IRS+1

Q: Are mandatory service charges or auto-gratuities eligible?
A: No—only tips that are voluntary from customers (including shared/pooling arrangements) are eligible. Mandatory service charges controlled by the employer typically are considered wages, not eligible tips. National Association of Home Builders+1

Q: Does this affect payroll tax withholding or employer responsibilities?
A: Not for 2025. Employers continue withholding and reporting tips as before. The deduction affects the employee’s income tax return. For 2026 and beyond, new W-2 codes and other reporting changes will apply. Employers should update payroll systems accordingly. Patriot Software

Q: Does the deduction apply to state income taxes?
A: No—state tax treatment is separate. Some states may tax tip income in the usual way unless or until the state enacts its own change. From the federal side, the deduction is for federal income tax only. Kiplinger

Q: What about tipped employees whose income is over the phase-out threshold?
A: Yes—the deduction phases out starting at MAGI of $150,000 for single filers ($300,000 joint). Above certain income levels, the deduction may be reduced or eliminated. IRS

Q: Do employees still have to report tip income to the employer?
A: Yes—employer tip-reporting obligations remain. Employees must report tips of $20 or more in a month to their employer by the 10th of the next month. Employers must continue to include tip income for payroll tax purposes. IRS+1

Q: What should employers do now?
A: Employers should maintain accurate tip records, implement tip‐pool/sharing compliance, prepare payroll systems for future reporting changes, educate tipped employees about the deduction possibility, and monitor IRS/Treasury guidance (including the publication of qualifying occupations).

Conclusion

The “no tax on tips” deduction represents a significant change in how tipped income is treated for federal income tax purposes. However, it does not change the fundamental payroll tax treatment of tips—they remain subject to Social Security and Medicare withholding and employer obligations. For payroll and accounting professionals, the key is to ensure tip reporting remains accurate, systems are updated for upcoming form changes, and employees are informed. With careful planning and coordination, employers can help ensure compliance and allow eligible tipped employees to benefit from the deduction.