The "no tax on tips" deduction is final: what tipped-employee businesses need to do

What changed

For 2025 through 2028, workers in tipped jobs can deduct up to $25,000 a year in tip income from their federal taxable income. It’s a new federal deduction (IRC Section 224), and the IRS finalized the regulations this spring, with an occupation list that finally answers “does this apply to my staff.” If you run a restaurant, bar, salon, or anywhere else people tip your employees, your staff are going to ask you about this, and some of what they’ve heard is already wrong.

Here’s what’s real, what isn’t, and what you actually need to do before year end.

The deduction itself

The $25,000 cap applies per tax return, not per spouse, so a married couple filing jointly where both partners wait tables doesn’t get $50,000. It phases out once modified adjusted gross income passes $150,000 for single filers or $300,000 for joint filers, dropping by $100 for every $1,000 of income above that line. By roughly $400,000 (single) or $550,000 (joint), the deduction is gone. For almost every server, bartender, or stylist you employ, none of that matters. They’re nowhere near those income levels.

It’s an above-the-line deduction, meaning employees don’t need to itemize to claim it. The IRS added a new Schedule 1-A to the 2025 Form 1040 specifically to handle this, along with similar new deductions for overtime pay and car loan interest, so your staff will see a line for it when they file.

What doesn’t qualify

This is where businesses get into trouble if they assume the deduction covers everything with “tip” in the name. The IRS final rule, effective June 2026, is specific: only voluntary tips count, meaning the customer decided the amount and nobody required it. Cash tips, tips added to a card payment, and tips through a pooling arrangement all qualify.

An automatic 18% gratuity added to a table of eight does not qualify. The IRS treats a mandatory service charge as a wage, not a tip, because the customer never had a choice about it. If a customer adds something extra on top of that mandatory charge voluntarily, that extra amount can qualify, but the baseline mandatory portion can’t. If your point of sale or bill-printing software lumps “service charge” and “tip” into one bucket, that’s worth fixing now, because your employees will need accurate records to claim this correctly.

The final regulations also list roughly 70 occupations the IRS considers tip-eligible, organized under categories like food and beverage service, hospitality, personal services, and transportation. Front-of-house restaurant and salon staff are squarely on it. If you have any doubt about a specific role, the full list is worth five minutes of your time before tax season.

Nothing changes about payroll

This is a federal income tax deduction, not a payroll tax exemption, and it’s worth saying plainly to your staff: you still withhold Social Security and Medicare on every dollar of reported tips, tips still show up on the W-2 the same way they always have, and Form 4137 still exists for anyone who didn’t report tips to you directly. The 7.65% combined FICA bite doesn’t go away. The IRS gave employers a break for 2025 specifically, you aren’t required to separately break out “qualified tips” on last year’s W-2s, but that’s a one-year reporting accommodation, not a change to withholding.

A worked example

Say a server earns $35,000 in reported wages and $18,000 in tips, all voluntary, no automatic gratuities. On their federal return, they can deduct the full $18,000, since it’s under the $25,000 cap, lowering their federal taxable income to roughly $35,000 instead of $53,000. Their FICA withholding throughout the year doesn’t change at all, since that’s calculated on the full $53,000 regardless of this deduction. If they live in California, their state return is a different story.

The California catch

California has not conformed to this federal deduction. As of this writing, a bill, SB 984, to do so is still pending in Sacramento and not yet law. Until it passes, California taxpayers have to add the tip deduction back on their state return, meaning tip income is taxed normally at the state level, up to 13.3% at the top bracket, even though it’s deductible federally. Tell your California employees this directly, because the “no tax on tips” headline makes people assume it means no tax at all.

What to actually do before year end

• Separate voluntary tips from mandatory service charges in your POS and payroll categories, if they aren’t already split out.
• Don’t touch your withholding setup. FICA calculations are unaffected by this deduction.
• Point staff to the IRS’s tip-eligible occupation list and Schedule 1-A instructions so they know what to expect on their 2025 return.
• Remind California employees the deduction doesn’t apply to their state taxes yet.

This is general information, not legal or tax advice. The fine print, occupation eligibility, phase-outs, and California’s conformity status can shift between now and when your staff actually file, so point anyone with a real question to a CPA. For more on how California treats tip handling on the compliance side, see our earlier post on SB 648 and credit card tip deductions.

Sources

• 26 U.S.C. Section 224, qualified tips deduction
• IRS Notice 2025-69, employer transition relief for tax year 2025
• IRS/Treasury final regulations on qualified tips and tip-eligible occupations, Federal Register, April 2026, effective June 12, 2026
• California SB 984 (pending), state conformity to the federal tips deduction