The U.S. Treasury Department released its anticipated proposed regulation on the new No Tax on Tips provision of the One Big Beautiful Bill Act (OBBBA). This regulation may have significant implications for workers in restaurants, hotels, and other sectors of the hospitality industry, as well as workers in many other fields.
Basics of the No Tax on Tips Law
OBBBA created a federal income tax deduction for tips that employees and certain independent contractors receive by adding Section 224 to the tax code. For tax years 2025-2028, individuals who receive qualified tips may deduct up to $25,000 of those tips annually from their taxable income (the NTOT Deduction). The NTOT Deduction is set to expire after 2028; as of now, tips will again be fully taxable starting in 2029.
The NTOT Deduction is an above-the-line deduction to determine adjusted gross income, making it available to tipped employees who do not itemize. However, the NTOT Deduction is not intended to reduce FICA taxes (Social Security and Medicare), so those taxes will still be due from both the employee and the employer on all tips received.
The tip recipient must be involved in an occupation that customarily receives tips to be eligible for the deduction. The proposed regulation lists numerous occupations that are potentially eligible for the NTOT Deduction. However, as later discussed, an employee in a listed occupation might not be eligible for the deduction because the law carves out several types of businesses for which the deduction does not apply.
Both employees and independent contractors may qualify, provided their occupation is included on this list. Independent contractors may claim the deduction if their business income (including tips) exceeds all business deductions. If a net loss is reported by an independent contractor, a tip deduction generally would not be allowed.
The proposed regulation would require employers to separately report all tips employees received on the Form W-2s issued to employees. To claim the deduction, a taxpayer must accurately report all tips received. A valid Social Security number is required, and undocumented workers are ineligible. Married taxpayers must file jointly to claim the NTOT Deduction.
Under the law, the deduction would phase out for individuals with modified adjusted gross income (MAGI) over $150,000 and for married couples with MAGI over $300,000. (MAGI is adjusted gross income plus certain foreign income and income from U.S. territories otherwise excluded from gross income).
Qualified Tips
For a tip to be eligible for the NTOT Deduction, it must be a “qualified tip,” meaning it must be paid voluntarily and free from compulsion to pay without consequences for nonpayment, not subject to negotiation and determined solely by the customer. The proposed regulation states that mandatory tips would not be qualified tips, citing, as an example, an 18% tip that is automatically added to a check for parties of six or more. However, according to another example, if a customer adds an extra 5% tip over and above the mandatory 18%, then the 5% additional tip is voluntary and thus classified as a qualified tip. This may introduce an additional layer of complexity since the restaurant is required to report the qualified tip on an employee’s Form W-2. As a result, employers generally would need to keep track of separate additional tips customers give on checks that also include a mandatory tip.
To make this more complex, the new NTOT Deduction rules are effective for tips received beginning Jan. 1, 2025, so with over nine months of the year already passed, restaurant employers who add mandatory tips to checks generally would need to account for the difference between voluntary tips that are eligible for the NTOT Deduction, and mandatory tips that are not eligible, going back to the beginning of 2025.
A recommended tip added onto a check may be a qualified tip if the customer is expressly notified that the tip amount can be reduced or removed completely. Since a qualified tip cannot be the subject of negotiation or made under compulsion, if there are suggestions given to the customer either verbally on in writing that tips are expected, the IRS might treat tips received under such circumstances as not qualified tips due to an element of compulsion.
For point of sale (POS) devices, to be a qualified tip, the customer must be given the option to leave no tip. If a tip amount must be given before the POS device allows the customer to continue to complete the credit card payment, then the proposed regulation states that the tip would not be a qualified tip, because the customer is not given the opportunity to reduce or eliminate the tip.
Tip-Sharing and Tip-Pooling Arrangements
Tips received by employees under a tip sharing or tip pooling arrangement may be qualified tips, provided that the occupation of the employee sharing the tips is listed in the proposed regulation as an occupation that customarily receives tips. For a restaurant, this would include all wait staff, “back-of-house” workers in the kitchen, host staff, and dining room attendants. Accordingly, most workers in a restaurant receiving tips through a tip sharing or tip pooling arrangement would be eligible to take the NTOT Deduction for qualified tips received under such an arrangement.
Occupations Eligible for the NTOT Deduction and Specified Service Businesses That Are Not Eligible
The proposed regulation lists numerous occupations that have customarily received tips and therefore are potentially eligible for the NTOT Deduction. These run the gamut, from the expected (workers in restaurants, valet parking attendants, hair stylists, manicurists, spa workers, golf caddies) to the unexpected (digital content creators).
In addition, people involved in entertainment, such as singers, musicians, comedians and dancers, are listed among the occupations that have customarily received tips. This may lead to some confusion, however, because specified service businesses, including businesses in the fields of law, accounting, health investment management, sports, and the performing arts, are excluded from the list. An example in the proposed regulation states that tips received by a comedian performing at an entertainment venue are not eligible for the NTOT Deduction because the comedian is engaged in the business of the performing arts, a specified service business.
Under the proposed regulation, this carve-out of specified service businesses not eligible for the NTOT Deduction is determined at the business level, not the worker level. The regulation cites, as an example, a musician who is employed by a hotel who plays the piano in the hotel’s lobby and receives tips. According to the example, the tips received by the musician are qualified tips because the musician is providing a performing arts service as an employee of the hotel, which is not a specified service business excluded from NTOT Deduction treatment. Meanwhile, bartenders and waiters employed by music venues and theaters would not be eligible for the NTOT Deduction because these businesses are involved in the performing arts field.
The proposed regulation does, however, provide that contract foodservice operator employees are eligible for the NTOT deduction. The regulation gives an example of a bartender who is employed by a food service company that provides food and beverage services for a theater. The example concludes that the tips received by the bartender are eligible for the NTOT Deduction because his employer, the food and beverage services company, is engaged in food and beverage services, which is not a specified service business excluded from the NTOT Deduction.
Effective Dates and Withholding Adjustments
The effective date of NTOT Deduction rules is Jan. 1, 2025. As a result, qualified tips received since the effective date may be eligible for the NTOT Deduction. However, the IRS has issued a notice stating that employers should not reduce withholding for 2025 for any of the tax saving provisions of OBBBA, including the NTOT Deduction. This means that employees who receive qualified tips may not see the benefit of the NTOT Deduction until they file their 2025 income tax returns and receive a refund resulting from this deduction.
The NTOT Deduction currently is slated to end after the 2028 tax year, so unless Congress extends this provision, tips will again be fully taxable beginning in 2029.