A new federal law gives tipped workers a major benefit at tax time. Employees in eligible occupations may now deduct a portion of their reported tips from federal taxable income. While the law offers meaningful savings for many workers, it also creates new responsibilities for employers who handle payroll and reporting.
The One Big Beautiful Bill Act (OBBBA) created an above-the-line deduction of up to $25,000 in reported tip income. This type of deduction reduces taxable income before calculating adjusted gross income, which means employees can take it even if they do not itemize deductions.
The deduction phases out for taxpayers with modified adjusted gross income above $150,000 for individuals, or $300,000 for joint filers, and is set to expire at the end of 2028.
To qualify, workers must be in occupations the IRS defines as “customarily and regularly receiving tips.”
Tipped workers such as servers, bartenders, hairdressers, and nail technicians are among those most likely to qualify. According to early estimates, eligible employees could see an average increase in take-home pay of about $1,675 annually.
Qualified tips include:
Cash tips reported to employers
Credit card and app-based tips
Tips received through pooling or sharing arrangements
However, it is important to note that not all service workers will benefit. Cooks, dishwashers, and other back-of-house staff who typically do not receive tips will not qualify. The Yale Budget Lab, a nonpartisan research center, estimates that about one-third of tipped workers already pay no federal income tax due to low wages, which means they may not see additional savings.
This new deduction does not remove all tax obligations on tips. Workers still owe Social Security and Medicare payroll taxes, and state or local income taxes may also apply. Noncash tips, such as tickets or gifts, remain taxable.
Employers must:
Report qualified tips accurately on IRS information returns
Withhold the correct payroll taxes on all tips, including cash
Update payroll systems to comply with new rules
Be aware of the expanded tax credit for certain industries, such as restaurants, that offsets payroll taxes on reported tips
The IRS has announced transition relief for tax year 2025, giving both employers and employees time to adjust. Still, payroll and HR teams should act early to avoid errors and penalties.
Employers in industries with tipped employees will face added reporting complexity. Updating payroll processes to capture and classify qualified tips will be essential. Human Resources and payroll teams should also be ready to:
Educate employees about reporting requirements
Adjust onboarding documentation for tipped roles
Track occupations that meet IRS eligibility standards
Communicate clearly about how tips affect paychecks and tax withholdings
For organizations that rely heavily on tipped employees, investing in integrated Payroll and Time & Labor Management systems can reduce the administrative burden.
The new tip income deduction could provide a financial boost for many service industry workers, but it also adds complexity for employers who manage payroll. Preparing now will help both employees and businesses take full advantage of the change.
©2025 - Content on this blog is intended to provide helpful, general information. Because laws and regulations evolve, please consult an HR professional or legal expert for guidance specific to your situation.