A First Look at ‘No Tax on Tips’

Prior Law

Historically, tips have been taxed in the same manner as wages or other compensation and are considered taxable when received. Employees must report cash tips to their employers, who then include them on the employee’s Form W-2 (IRC § 6053). For employment tax purposes, only cash tips are taxable [IRC § 3121(a)]. (Prior law also excludes a de minimus amount each month, but this is disregarded here for simplicity.)

Prior law does not include a definition that distinguishes tip income from other types of compensation; however, there is definitional guidance for employment tax purposes. Revenue Ruling 59-252, 1959-2 CB 215 provides four criteria for an amount to be treated as a tip:

• The payment must be presented by the customer free from compulsion.
• The customer has the unrestricted right to determine the amount thereof.
• The amount is not the subject of negotiation or dictated by employer policy.
• The customer generally has the right to determine precisely who receives the payment.

Revenue Ruling 2012-18, 2012-26 IRB 1032 clarifies this definition by providing that mandatory charges, such as service charges or automatic gratuities for large parties, are treated as wages rather than tips.

New Law

Congress recently passed the OBBBA which includes temporary changes to the way tips are taxed in section 70201 of the act. The legislation adds a new deduction for qualified tips that are either reported to the employer, or self-reported for self-employed taxpayers, as required under current law. The deduction would equal tipped income up to a maximum of $25,000 per year, or up to the amount of net profit made for self-employed taxpayers, for the years 2025–2028. This deduction phases out beginning at $150,000 of adjusted gross income (AGI; $300,000 for joint filers). The new law defines eligible tipped income as cash tips in occupations that customarily receive tips as of December 2024. The Treasury issued proposed regulations on September 19, 2025, “Occupations that Customarily and Regularly Received Tips: Definition of Qualified Tips” to provide this guidance (https://tinyurl.com/39mcbez2). The deduction would be available to taxpayers, regardless of whether they choose to itemize or use the standard deduction and other allowable adjustments to gross income. Filers utilizing this deduction are required to furnish their Social Security number on the attached form and must file jointly if married. This provision is scheduled to sunset in 2028.

The new legislation does not affect the taxation of tips for employment tax purposes, so tips will continue to be taxed differently for those two taxes. This means that a definition of tips for income tax purposes is needed. The new law includes some definitional guidance but still allows for interpretation by the Secretary of the Treasury. This guidance is presented in the form of exclusions from the definition of tips:

As the new law includes language similar to that in Revenue Ruling 2012-18, the authors believe it is likely that the guidance will ultimately consist of similar elements to distinguish tips from service charges. The analysis below assumes that the legislation and forthcoming guidance will adopt this employment tax definition of tips.

Analysis and Calculations

To evaluate the potential impact of “no tax on tips,” the authors calculated a potential tax liability for bartenders under both the previous law and new law, as illustrated in Exhibit 1. This analysis was completed before the final passage of the new legislation. The analysis was based on the provisions in S.129 (the Senate bill), which included a deduction capped at $25,000 but no income limitation. These differences, along with other minor differences between this and the final legislation as passed, do not materially affect our analysis. Bartenders were chosen because this occupation is familiar to most people, and bartenders often derive a significant portion of their income from tips. Independent variables included annual income, nationwide weighted average minimum wages for bartenders (calculated in Exhibit 2), the standard deduction, and applicable marginal tax rates.

The weighted average tipped minimum wage captures wage disparities among bartenders nationwide. Using employment and wage data from the US Department of Labor and the US Bureau of Labor Statistics, the number of bartenders per state was multiplied by the tipped minimum wage to establish a base amount per state. These were then summed to obtain a total base amount nationally and summed the number of bartenders per state to determine the total number of bartender jobs nationally. The national base amount was then divided by the total number of bartender jobs to determine the weighted average. This method accounts for labor market differences, offering insight into wage equity and policy implications for service workers. The results indicated that the average single taxpayer in a tipped occupation could see a tax savings of approximately $1,985 in 2025, equivalent to about 5.9% of annual income for many bartenders.

In addition to tax liability modeling, the authors conducted a regression analysis using state-level data to determine if the relationship between the state’s minimum wage for bartenders and the resulting tax savings was statistically significant. Minimum wages for bartenders were used as the independent variable, while the estimated deduction amount under the new legislation served as the dependent variable (Exhibit 3 illustrates these calculations per state). The analysis revealed a statistically significant negative relationship (β = -881.76, p < .01), with lower minimum wages for tipped workers associated with higher deductions. The model explained approximately 26% of the variance (R² = 0.259), and the correlation coefficient of –0.523 further supported this inverse relationship. These findings suggest that workers in lower-wage states may receive greater tax relief under the deduction up to the $25,000 cap.

Policy Implications

While these findings highlight the potential tax benefits for some workers, they also raise significant concerns regarding tax policy and equity. The deduction’s structure favors jurisdictions with lower minimum wages for tipped workers, potentially reinforcing existing disparities in compensation. In contrast, workers in higher-wage states—where the financial burden is more concentrated in base wages—may see limited benefit. As illustrated in Exhibit 4, Washington, which has the highest minimum wage for bartenders at $16.28, receives an estimated deduction that is $728 smaller than that of Louisiana, one of the states with the lowest minimum wage for bartenders. This uneven distribution complicates efforts to ensure equitable tax relief nationally.

The law’s broader fiscal implications are also significant. Estimates from the Tax Foundation (Alex Muresianu, “How ‘No Tax on Tips’ Could Backfire,” Tax Foundation, January 2025, https://taxfoundation.org/oped/no-tax-on-tips-could-backfire) project a federal revenue loss of $118 billion over the next decade, rising to nearly $200 billion if payroll tax exemptions are included. The final legislation does not exempt this tip income from employment taxes, but this is one possibility to watch in the future.

Moreover, the legislation’s effectiveness in reaching its intended beneficiaries is uncertain. Estimates indicate that a significant amount of tipped income is not reported to employers and, therefore, not taxed for income or employment tax purposes. The Treasury Inspector General for Tax Administration (TIGTA) estimates that unreported tips for 2016 were nearly $1.66 billion (TIGTA, “Billions in Tip-Related Tax Noncompliance Are Not Fully Addressed and Tip Agreements Are Generally Not Enforced,” Reference Number: 2018-30-081, September 2018). Workers who underreport their tip income will likely not benefit from this provision. In addition, many low-income tipped workers who do report their tips already pay little or no federal income tax (as shown in the calculations). According to the Yale Budget Lab (Ernie Tedeschi, “The ‘No Tax on Tips Act’: Background on Tipped Workers,” Budget Lab, June 2024, https://budgetlab.yale.edu/news/240624/no-tax-tips-act-background-tipped-workers), over one-third of tipped workers earned too little to owe federal income taxes in the prior year, even before accounting for refundable credits. As a result, the deduction may disproportionately benefit higher-earning service workers, while offering minimal relief to those most in need.

The final legislation provides that the deduction will only be available from 2025 to 2028. In addition, the deduction would apply only at the federal level, unless adopted by individual states or municipalities, so taxes on tips remain at those levels.

There are also concerns about unintended interactions with existing tax credits. Because eligibility for the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC) is based on a version of income that only includes taxable income, effectively exempting tips could reduce access to these benefits. The current law appears to stipulate that this deduction would not impact eligibility or the calculation of these credits; however, this is a potential issue for many taxpayers to consider.

Finally, the new law may influence labor market dynamics. By incentivizing tipping, it could encourage the expansion of tipping practices into new professions or lead employers to rely more heavily on tipped compensation structures. The new law requires the IRS to provide a list of “traditionally tipped professions,” which appears designed to deter the expansion of tipping professions. As mentioned above, the IRS has now issued proposed regulations to provide a list of the professions included. Until such a list is finalized, however, the risk remains. While some workers, particularly those in higher-earning service jobs, may see tax savings, the broader implications suggest that the policy could disproportionately benefit employers while doing little to resolve fundamental wage issues in the service industry. Under this legislation, employees receive a higher net-of-tax wage when a greater portion of their earnings is derived from tips. These structural shifts could further entrench below-minimum wage practices, raising concerns about long-term labor equity. A nuanced approach to tax reform is essential to ensure that well-intentioned policies do not inadvertently exacerbate existing disparities in compensation and taxation.

Unresolved Issues

As this analysis demonstrates, the “no tax on tips” provision in OBBBA presents both opportunities and challenges for tax policy, labor equity, and fiscal planning. While the projected median tax savings of approximately $1,985 could offer meaningful relief to some service workers, the broader implications raise several unresolved issues.

One issue is that this deduction is only available to workers in specific fields for certain types of income. Workers who earn tips but are not included in the “tipped professions” for tax purposes will still be required to pay taxes on their tip income. In addition, if the goal is to assist lower-income taxpayers, this bill excludes many occupations that make approximately the same amount as those in tipped professions but are not paid by tips. For example, “back of house” restaurant and bar employees like cooks and dishwashers, police officers, teachers, sanitation workers, and many others are in the same general income category and receive no benefit from this provision.

One major concern is the potential for underreporting income at the state and local levels, as well as for employment tax purposes, which could complicate enforcement and compliance. If tipped workers do not clearly understand that “no tax on tips” really means “no federal income tax on tips,” they could easily underpay taxes in these other areas.

This analysis further highlights regional disparities in the bill’s impact. Employees in states with lower tipped minimum wages stand to benefit more from the deduction, raising equity concerns about the distribution of tax relief. While some workers—especially those in higher-earning service roles—may experience tangible tax savings, the broader implications suggest that the policy could disproportionately benefit employers while doing little to address underlying wage structures in the service industry.

Beyond taxation, the new law may influence labor market dynamics. It could incentivize employment in tipped professions, shift workforce distribution, or even alter consumer tipping behavior. Whether these changes would stimulate economic growth or merely provide marginal relief remains uncertain. Ultimately, while the bill aims to support low-income workers, its narrow scope—affecting only about 2% of the US population (Tedeschi, 2024) and limited benefit for many within that group suggests it may fall short of its intended goals.