Article Highlights:
- Prior Law on Tip Reporting and Employer Requirements
- Introduction of the Above-the-Line Deduction for Qualified Tips
- Above-the-Line Deductions
- Qualified Tips Definition
- Tips in Business Operations
- When the Deduction is Unavailable
1.Specified Service Trades or Businesses
2.Income Based Reduction
3. Lacking Employment-Eligible Social Security Number
- Expanded FICA Tip Tax Credit for Employers
The tax landscape in the United States is always changing due to legislative updates, and one recent change presented in the "One Big Beautiful Bill Act" is a new above-the-line tax deduction for eligible tips. This article goes into the history and current state of tip taxation, focussing on the consequences of the new deduction for workers in tipping-based occupations.
Prior Law on Tip Reporting and Employer Requirements: Historically, under US tax law, employees who received tips were obligated to declare any tips totalling $20 or more each month to their employer. This report is sent in writing to the employer by the 10th of the following month. Employers, in turn, must withhold both FICA (Social Security and Medicare) and income taxes on reported tips. These sums were subsequently recorded on the employee's Form W-2 and reported as income on the employee's income tax return. Failure to declare tips may result in the IRS imposing a penalty on the employee, which is normally 50% of the employee's share of FICA taxes on unreported tips.
Furthermore, for more than 40 years, employers in bigger food and beverage establishments—specifically those with customary tipping and 10 or more employees—have been compelled to distribute tips among staff. The allocation ensured that total reported gratuities by employees accounted for at least 8% of the establishment's gross revenue. If reported tips fell short of this standard, the employer was required to make up the difference.
The former law included an interesting provision called the Employer Social Security Credit, which allowed food and beverage enterprises to claim a credit for Social Security taxes paid on employee tips. The credit was calculated using IRS Form 8846 and applied to the 'excess' employer social security tax, which was paid on reported tips that above specific minimum wage criteria.
Introduction of the Above-the-Line Deduction for Qualified Tips. With the adoption of the One Big Beautiful Bill Act, workers in some tip-based professions get a major new tax benefit: an above-the-line deduction of up to $25,000 for qualifying tips. The provision, however, is just temporary, lasting from 2025 to 2028. The $25,000 cap applies per tax return, regardless of filing status, rather than to individuals. This means that regardless of filing status, the annual deduction limit for the tax return remains at $25,000.
Above-the-Line Deductions - These are deducted from gross income to calculate adjusted gross income (AGI). Thus, they can be beneficial because they reduce taxable income regardless of whether a taxpayer uses the standard deduction or itemises deductions. Such deductions can also have an impact on eligibility for other tax benefits that are subject to AGI limits. While eligible tips up to the ceiling are now income tax-free, employee tips are still subject to FICA withholding, and self-employed tip recipients may be required to pay self-employment tax on them.
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To qualify for this deduction, tips must meet the following criteria:
- Given voluntarily.
- There are no consequences for nonpayment.
- Are non-negotiable, and the amount is established by the payer.
- The trade or business that receives the tip is not a specified trade or business under Sec 199A(d)(2),
- Future regulations may impose further restrictions.
This clause applies to both W-2 workers and independent contractors who may receive tips in various forms such as 1099-K or 1099-NEC, assuming the occupation is recognised as qualifying by the Treasury Department. The administration plans to issue a list of qualified professions by early October 2025.
- Tips for Business Operations (Self-Employment):
- Tips generated when doing self-employed business activities must be included in the business's gross income.
- Deductive Eligibility: Self-employed individuals' tips are also eligible for a tip deduction under the stipulated limits ($25,000 maximum per year), as long as the business from which the tips are received qualifies (see next). However, if the taxpayer's business deductions exceed the company's gross income, including tips, the tip deduction would be reduced.
- When the Deduction is Not Available - There are restrictions on when this deduction can be used.
1.Specified Service Trades or Businesses: The tax code distinguishes between ordinary business trades and specified service trades or businesses under Section 199A(d)(2). Workers in certain service areas, including health care, law, accounting, and consulting, are ineligible for this deduction. These trades, which can include numerous occupations other than food and beverage, frequently rely largely on their employees' reputations or skill levels.
2. Income-Based Reduction – The income-based reduction rule adds to the complexity of computing this new deduction. For individuals with an adjusted gross income (AGI) greater than $150,000 or $300,000 for joint filers, the deduction is decreased by $100 for every $1,000 beyond the AGI threshold.
3. Filing Status - To receive this deduction, married taxpayers must file a joint return.
4.Social Security Number (SSN) Requirements: A genuine, work-eligible SSN is required for anyone claiming the deduction to ensure compliance and validate income against IRS data.
- The One Big Beautiful Bill Act includes an amendment that expands the FICA tip tax credit. Previously limited to food and beverage enterprises, it now includes beauty services. This expansion enables hair care, nail services, aesthetics, and spa treatment businesses to claim a credit for a portion of their Social Security taxes paid on employee tips. This increase recognises the ubiquity of tipping in these additional service industries, correcting a mistake in previous legislation.
The inclusion of an above-the-line deduction for qualified tips in the new legislation is a watershed moment, recognising the unique nature of tip revenue in today's economy. By cutting taxable income straight from AGI, qualifying workers receive significant tax relief. However, complexities around eligible professions and the exclusion of high earnings complicate the situation, emphasising the importance of persons in these professions consulting with tax professionals to maximise their benefits under this new law. Furthermore, the expanded FICA tip credit benefits employers in previously neglected industries, indicating a positive step towards tax policy adaptation to modern professional realities.
If you are a tipped employee, self-employed individual, or employer and want to know how the latest tax law changes may effect your situation, please contact our office.