No tax on tips: what restaurant and service business owners should know

Published Thursday 20 August 2026

Table of contents

• What is the "no tax on tips" deduction?
• Which occupations qualify for the tip deduction?
• What counts as a qualified tip?
• What employers need to do right now
• What stays the same for employers?
• How state taxes affect the tip deduction
• Common misconceptions about no tax on tips
• Take the stress out of tip tracking and payroll
• FAQs on no tax on tips

Key takeaways

• Employees who receive tips can now deduct up to $25,000 per year from their federal taxable income, retroactive to January 1, 2025, and running through December 31, 2028.
• The deduction applies to 70+ qualifying occupations across restaurants, hospitality, and personal services, but only voluntary tips count; automatic gratuities and service charges are excluded.
• Employers don't need to change payroll withholding or reporting for 2025, but starting in 2026, you'll need to report qualified tips on employees' W-2 forms.
• Social Security, Medicare, and federal unemployment taxes on tips haven't changed, so your payroll obligations as an employer stay largely the same.

What is the "no tax on tips" deduction?

The One Big Beautiful Bill Act (OBBB), signed into law on July 4, 2025, created a new federal income tax deduction for workers who receive tips. The deduction lets qualifying employees and self-employed individuals exclude up to $25,000 in tip income from their federal taxable income each year.

The deduction is retroactive to January 1, 2025, and is set to expire on December 31, 2028. It's designed to put more money in the pockets of tipped workers, and it affects how you'll handle tip reporting on your team's W-2 forms starting in 2026.

How the deduction works

The tip deduction is an above-the-line deduction, which means your employees can claim it whether they take the standard deduction or itemize. They'll claim the deduction on their individual tax returns using the new Schedule 1-A form.

As an employer, your role is to make sure tips are reported correctly on W-2s so your employees can take full advantage of the deduction when they file.

How it affects employee taxes

Deductions reduce taxable income – for example, if an employee's taxable income is $50,000 and they claim a tip deduction for $10,000, the deduction reduces their taxable income to $40,000.

The exact savings depend on the employee's tax situation. For example, a server in the 12% federal tax bracket who earns $25,000 in qualified tips during the year would save $3000 in federal income taxes. That's a meaningful saving worth communicating to your team.

Income phase-out thresholds

The deduction isn't available to everyone at the full amount. First, it's available per return – not per person. So a single filer can deduct up to $25,000, but a married couple filing jointly is also capped at that amount. Married couples who file separately typically can't claim it at all.

Also, it begins to phase out for employees whose modified adjusted gross income (AGI) exceeds certain levels:

• $150,000 for single filers
• $300,000 for married couples filing jointly

For every $1000 of income above these thresholds, the deduction decreases by $100. An employee earning $175,000 as a single filer, for example, would see their maximum deduction reduced by $2500.

Which occupations qualify for the tip deduction?

The U.S. Department of the Treasury has identified more than 70 qualifying occupations organized into eight categories. If your business employs tipped workers, there's a good chance at least some of your team qualify.

Restaurant and food service roles

Most front-of-house restaurant positions qualify for the deduction. These roles include:

• servers and waitstaff
• bartenders
• hosts and hostesses
• bussers and food runners
• baristas

If you tip out to the back-of-the-house, they qualify too. The list includes chefs, cooks, and bakers.

Hospitality and personal services

The deduction extends well beyond restaurants. Qualifying roles in hospitality and personal services include:

• bellhops and hotel concierge staff
• valets and parking attendants
• hairdressers and barbers
• nail technicians and estheticians

Even maids and desk clerks qualify – but in all cases, employees can only claim the deduction if the tips are reported on their W-2.

Other qualifying occupations

Several other tipped occupations also qualify, including:

• rideshare and delivery drivers
• golf caddies
• personal trainers and fitness instructors
• tour guides

The list of eligible occupations includes everyone from plumbers to tutors to shoe repairers to travel guides, and if your employees receive tips, you should check it out to make sure you're reporting everything correctly.

Who doesn't qualify?

Not every worker who receives tips is eligible. The deduction excludes:

• professionals in healthcare, law, and accounting
• roles that didn't customarily receive tips before January 1, 2025
• employees whose income exceeds the phase-out thresholds described above

The Treasury Department assigns each qualifying occupation a Treasury Tipped Occupation Code (TTOC). You'll use these codes on W-2 forms starting with the 2026 tax year.

What counts as a qualified tip?

Not all tips are treated the same under the new law. Understanding which types of tips qualify for the deduction will help you guide your employees and keep your records clean.

Tips that qualify

Your employees can claim the deduction on tips that are:

• Voluntarily left by customers in cash
• Added by customers to credit or debit card payments
• Sent through digital payment apps
• Distributed through a tip pool, as long as the original tips were voluntary

The keyword is "voluntary." The customer has to choose to leave the tip without being required to do so.

Tips that don't qualify

Certain types of payments look like tips but don't count under the new deduction:

• Automatic gratuities added to a bill (for example, an 18% service charge on parties of six or more)
• Mandatory service charges set by the business
• Non-cash tips, such as gift cards or merchandise
• Cash tips that aren't reported to the employer

If your restaurant adds automatic gratuities, those payments are classified as service charges, not qualified tips. Your employees can't include them when claiming the deduction.

What employers need to do right now

Your to-do list depends on which tax year you're preparing for. The IRS has provided transition relief for 2025, which means your immediate workload is lighter than you might expect.

For the 2025 tax year

You didn't need to make any payroll system changes for 2025. Here's what applied:

• The IRS granted transition relief for 2025, so there were no new W-2 reporting requirements for that tax year. If you haven't issued 2025 W-2s yet, you can create them as you usually do.
• Employees claim the deduction on their own tax returns using the Schedule 1-A form — if they ask, let them know they can use their final 2025 pay stubs to see their tip income for the deduction.
• If employees wanted to adjust their withholding to reflect the expected tax savings, they could review and update their W-4 forms.
• You reported tips as you normally would, with no special year-end steps required.

For the 2026 tax year

Starting with the 2026 tax year, new W-2 reporting requirements kick in. You'll need to:

• Report each qualifying employee's Treasury Tipped Occupation Code (TTOC) in Box 14b of their W-2.
• Report qualified tip amounts in Box 12 using the new code "TP".
• Track qualified tips separately from service charges and automatic gratuities in your payroll records.
• File Form 8027 if you're a large food or beverage establishment (this requirement already exists, but accurate tip tracking becomes even more important).

Employer payroll checklist

Follow these steps to stay on track:

1. Review which of your employees hold qualifying tipped occupations.
2. Look up the correct TTOC for each qualifying role on the IRS website.
3. Confirm that your payroll system can track qualified tips separately from service charges.
4. Update your payroll software or work with your provider to add Box 12 code TP and Box 14b TTOC fields for 2026 W-2s.
5. Communicate with your team about the deduction and encourage W-4 updates.
6. Set a reminder to review IRS guidance updates before year-end.

What stays the same for employers?

While the new deduction changes how your employees are taxed on tips, it doesn't change most of your payroll obligations. The following obligations remain in place:

• Federal income tax withholding on tips continues as normal.
• Social Security tax at 6.2% still applies to tip income (both the employer and employee shares).
• Medicare tax at 1.45% still applies to tip income.
• If you qualify, you can still claim the employer portion of Medicare and SS tax on tips back as a credit on your business income tax return.
• Federal Unemployment Tax Act (FUTA) obligations are unchanged.
• Your existing tip reporting requirements to the IRS remain in place.

The deduction is claimed by the employee on their individual tax return. It doesn't reduce the wages subject to payroll taxes, so your payroll costs on tipped wages stay the same.

How state taxes affect the tip deduction

The federal tip deduction doesn't automatically apply to state income taxes. Each state decides independently whether to conform to the new federal provision.

As of May 2026, 19 states have conformed to the federal tip deduction. If your business operates in one of these states, your employees may also be able to deduct qualified tips from their state taxable income.

If your state hasn't conformed, your employees' tips are still subject to state income tax even though they can claim the federal deduction. This is worth mentioning to your team so they aren't caught off guard at tax time.

Check your state's department of revenue website for the latest guidance. State conformity can change through legislative action at any point.

Common misconceptions about no tax on tips

There's a lot of confusion around this new law. Here are four common misconceptions you and your team should watch out for.

"Tips are completely tax-free now"

They aren't. The deduction only applies to federal income tax, and it's capped at $25,000 per year per return. Social Security, Medicare, and most state taxes still apply to tip income.

"I should stop withholding taxes on tips"

It's complicated. As an employer, you're still required to withhold federal income tax, Social Security, and Medicare on reported tips, but if your employee provides an updated W-4, your payroll software will automatically calculate their withholding in light of the tip deduction. The deduction is something your employees claim on their tax returns; it doesn't necessarily change your withholding obligations.

"All gratuities qualify"

They don't. Only voluntary tips count. Automatic gratuities, mandatory service charges, and unreported cash tips are all excluded from the deduction.

"This is a permanent change"

It's not. The tip deduction is temporary. It applies to tax years 2025 through 2028 and is currently set to expire on December 31, 2028, unless Congress extends it.

Take the stress out of tip tracking and payroll

Keeping up with tip reporting, new W-2 codes, and changing tax rules is a lot to manage on top of running your business. Xero's cloud-based accounting software helps you track income and stay organized so you can spend less time on the books and more time with your customers. It also integrates with payroll software for easy payroll runs.

Whether you're preparing for the new 2026 reporting requirements or just want a clearer picture of your finances, Xero gives you the tools to stay on top of it all.

Ready to simplify your books? Get 90% off for 6 months and see how Xero can help you manage tips, payroll, and everything in between. Explore Xero's payroll integrations to learn more.

FAQs on no tax on tips

Here are answers to some of the most common questions about the new federal tip deduction.

Do I need to change how I run payroll for 2025?

No. The IRS has provided transition relief for the 2025 tax year, so there are no new payroll reporting requirements yet. Your employees will claim the deduction on their individual tax returns, and you can handle end-of-year reporting as usual.

What is a Treasury Tipped Occupation Code (TTOC)?

A TTOC is a code assigned by the Treasury Department to each qualifying tipped occupation. Starting with the 2026 tax year, you'll report your employees' TTOCs in Box 14b of their W-2 forms.

Do automatic gratuities count as qualified tips?

No. Automatic gratuities and mandatory service charges are classified as non-tip wages. Only voluntary tips left by customers qualify for the deduction.

What if my employees earn more than $150,000?

The deduction phases out above certain income levels. Employees approaching those thresholds should talk to a tax advisor and consider updating their W-4 to make sure their withholding is accurate.

Does this apply to self-employed workers who receive tips?

Yes. Self-employed individuals in qualifying tipped occupations can also claim the deduction. However, the deduction can't exceed their net income from the business where they earn tips, and the tips must be shown on a 1099 form.

What happens after 2028?

The tip deduction is set to expire on December 31, 2028. Unless Congress passes new legislation to extend or make it permanent, tips will once again be fully subject to federal income tax starting in 2029.