Challenges with Tip Income Deduction, Particularly for 2025

I've blogged already on the inequities of the tip income deduction (9/10/25 post).  It also has some recordkeeping and compliance challenges for employers and employees, and payors and contractors. These challenges will be greater for 2025 because tipped workers won't have their qualified tips separately reported on their W-2, or 1099-NEC or 1099-K. That won't happen until 2026.

Recently, the IRS provided relief to employers and 1099 filers for 2025 because otherwise they could face penalties for not reporting the qualified tips. The IRS does encourage employers and others to find some way to get information to employees on their qualified tip amount and occupation code, such as via a written statement or online portal (see IR-2025-110 and Notice 2025-62).

Now you might think, don't tipped workers know how much their tip income is?  Well, they might, but do they know what their "qualified" tip amount was?  They are not the same thing!

For example, the following are tips, but not qualified tips that will generate a deduction for the worker.

• Tip received by a waiter at a restaurant but it was automatically added to the bill such as because it was a party of 6. This is not voluntarily paid so is not a qualified tip, even if the restaurant gave it to the waiter.
• The employee works for an employer who is a "specified service trade or business" (SSTB), such as theater or other performing arts business. This might also be confusing for employees with multiple jobs. For example, the bartender employee at the restaurant gets qualified tips (if paid voluntarily), but when she works at the performing arts center as an employee, those tips are not qualified.
• The worker might not be in one of the many listed occupations per a table in the proposed regulations (§1.224-1 at REG–11003225 (9/22/25)). The IRS says it will have the lists at this website, but it is not operational at 11/15/25 - https://www.irs.gov/TippedOccupations. 
• The tipped worker is an independent contractor such as a gardener without a 1099. Their tips are only qualified if they are reported on a Form 1099-NEC or 1099-MISC or 1099-K. If the gardener works for households and gets paid in cash, they won't get a 1099.  If they do work for businesses, they will get a 1099-NEC for 2025 if paid $600 or more. I'm assuming the contractor reports all income including the tips.  As soon as they can, contractors who don't get a 1099, such as because paid in cash by households, they should start taking credit or debit card or PayPal or Venmo so they will get a 1099-K.  We still don't know how PayPal and Venmo will get the tip info, likely they will be required to have the payor specify these amounts.

There is a lot of work here, particularly for the issuers of the W-2 and 1099s.  For example, one example in the proposed regulations is a restaurant where the point of sale machine only offers 3 options on tips:15%, 18% and 20%.  Since there is not an option to put in your own number including zero, this is not voluntary. BUT, since 15% is the minimum in this scenario, if someone tips 18% or 20%, that differential is a qualified tip!  Of course, the restaurant or other establishment with this fact pattern will need to have its recordkeeping system set up to capture this.

Payors will definitely want to get recordkeeping systems ready very soon to be ready to report qualified tips on reporting forms. They might also want to see about changing customer billing arrangements to ease compliance, by, for example, making all tip amounts voluntary.

What do you think?

18th Anniversary of the 21st Century Taxation Blog

Well, I'm amazed to be marking today the 18th anniversary of starting this 21st Century Taxation Blog - and that we are still in need of having a 21st century tax system that reflects how we live and do business today. 

Today, I'll note the 2025 IRS Dirty Dozen list which was a topic of a webinar I delivered today for CCH/CPELink. I delivered a webinar on the 2024 list last year. In diving deeper into the list, I went back to its start in 2001 when there were just 8 items. I like to share with others work that I find helpful to me, so I posted by list of the Dirty Dozen items since 2001.  I categorize them into 3 broad areas:

1. Tax Shelters and Questionable Tax Minimization Strategies Involving Taxpayer Funds

2. Thefts and Other Frauds and Scams Against Taxpayers, Employers and Tax Preparers (mostly bad actors trying to get your money)

3. Fakes - Improper Reporting and Preparer Fraud (mostly improper ways to get money from the government)

See my chart here - https://www.sjsu.edu/people/annette.nellen/website/DirtyDozenTable.pdf

icymi - other items I post for reference you might find useful are lists of all Treasury regulations, and other official guidance from the IRS going back to 2011. The relevant Code sections for each item are listed and if it ties to a specific piece of tax legislation. And there are links to get the full text.  This can be useful to see what has been issued or if someone tells you there was, for example, a 2022 revenue ruling on the topic but they don't recall the number.  See the 2025 list and links to past lists here - https://www.sjsu.edu/people/annette.nellen/website/2025regs.html. 

I also have a variety of tax items posted here - http://www.21stcenturytaxation.com/

Looking forward beyond18 years of tax blogging, I want to focus more on how to improve tax and budget literacy so people can better understand their own taxes, and also understand how the system works and how to get involved in asking good questions of elected officials about tax changes as well as the logic (or lack of logic) of some existing tax rules. Quick example, only about 3% of employees earn tip income which Congress is about to exclude from income taxes. Where are the 97% of employees who don't have this type of income? Why not ask for a higher standard deduction or reduce the lowest two tax brackets to 9% and 11% (rather than 10% and 12%) to benefit far more individuals?  [For more on the tip income deduction, see my post of 2/23/25]

My goal in creating this website and blog was to highlight how tax systems can be improved to reflect how we live and do business today and to reflect principles of good tax policy.

I very much welcome comments and suggestions.

Thank you for reading!

What's So Special About Tips to Make This Income Non-taxable?

Both presidential candidates offered a tax law change to make tips non-taxable. A few days after the inauguration, President Trump was in Las Vegas at a rally for "No Tax on Tips."  What is so special about tips to justify a law change to make then non-taxable?  I can't think of any, but offer these observations to remind us that tips are income just like wages and business income and there is little reason to provide a tax break to these workers - why not provide a tax break to all workers?

1. Tips are income: Income is defined by the US Supreme Court as "an undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion" (Glenshaw Glass, 348 US 426 (1955)). Some people suggest tips are gifts so are not taxable. A gift is defined by the US Supreme Court as something given with "detached and disinterested generosity" where the donor expected or expects nothing in return (Duberstein, 363 US 278 (1960)). Someone who receives services at a restaurant, hotel, hair salon, or similar establishment, might offer a tip because they appreciated the service and the amount likely varies by how much they liked the service. It is not a gift. If the giver wants to make a gift to someone they should go up to a stranger and give them money with no expectation of anything in return - that is a gift.

2. More than tipped workers need tax relief: H.R. 8785, Tax Free Tips Act (118th Congress) would have changed the law to say that wages do not include tips and make them not subject to income or payroll taxes. The sponsors offered as a rationale that many people getting tips might be "working a second job to make ends meet" so should be able to keep their money. That sounds reasonable if we are talking about raising the standard deduction for ALL low-income workers, but why single out or assume that only tipped workers are in need of tax relief.

3. Challenges of defining tipped workers: It looks like the key proposal in the 119th Congress based on the number of sponsors is No Tax on Tips Act. It would exempt cash tips from income tax (not payroll tax) and has "guardrails to ensure only traditionally tipped employees will benefit from" the proposal (see 1/16/25 sponsor press release). Do note that it says employees. Thus, contractors, such as your Uber driver and owner of a business, would not benefit from the tip deduction. The deduction is limited to $25,000 for the year and would not apply if the worker's income exceeds $160,000 (this is the amount per the reference to §414(q) in the bill). "Qualified tips" for the deduction are defined as "any cash tip received by an individual in the course of such individual's employment in an occupation which traditionally and customarily received tips on or before December 31, 2023, as provided by the Secretary." Thus, the Treasury and IRS would have to define this employee group.  I think that means that there isn't already a list of traditionally tipped industries.

4. Tip versus Service Charges: Some restaurants including ones in DC, automatically add a charge to restaurant bills such as because it was for a group of 6 or more (in DC, even 1 customer gets a 20% fee added). Is that a tip or something else (the DC one appears to be a service charge)? For tax purposes today for rules relevant on tip reporting, a service charge is not a tip (Rev. Rul. 2012-18). The fee is wages if distributed to employees. Will any legislative proposal address whether "forced" tips or service charges are the traditional and customary tips to be non-taxable? Arguably, I think yes, but to me it just doesn't seem like a tip when the business adds the amount to your bill automatically. But this should be addressed in any legislative change (in defining "tip").

5. Challenge of excluding tips from Social Security/Medicare taxes and state income taxes: Any tax big tax bill this year will likely be accomplished via the Budget Reconciliation process so that only 51 votes are needed in the Senate. This process does not allow for changes to Social Security so any tip exclusion in the bill can only remove income taxes (as proposed with No Tax on Tips Act (see 3 above)). Also, I think most states will opt not to conform to a federal exclusion or deduction if enacted due to the loss of revenue and the inequity of providing a tax cut to only a small number of employees. The Budget Lab at Yale estimates that 2.5% of workers earn tip income. At the 1/25/25 rally in Las Vegas, President Trump said over 4 million workers receive tip income and that about 25% of a typical restaurant worker's pay is from tips. Will a state enact a tax change to let about 3% of employees exclude 25% of their pay from taxes with no break to other employees who are at the same pay levels? I don't think so.

6. Permanent or temporary: Will any exclusion or deduction for tip income be a permanent change or temporary? I think if the extension of TCJA expiring tax cuts is temporary, the change for tip income will also be temporary, but who knows.

So, there is a lot to consider on this topic that affects a relatively small number of employees. Given the tax cut for a small number, will other employees, particularly those making minimum wage or a bit more also ask for an equivalent tax cut?  I think they should to improve the equity of the proposal - that is, similarly situated taxpayers based on income should be treated similarly. If a tipped employee making $70,000 including tips gets a tax cut, a non-tipped employee also making $70,000 should also get the same tax cut.

What do you think?