The legislation known as One Big Beautiful Bill Act of 2025 (OBBBA) introduces a major change to how tip income is treated for federal tax purposes. Starting with tax year 2025, legislation allows eligible workers to deduct up to $25,000 in reported tip income from their federal taxable income.

Here’s a breakdown of what the law states, who qualifies, who doesn’t, and what tax professionals should consider when advising clients.

Key provisions of the no tax on tips

• Annual deduction limit: Maximum annual deduction is $25,000; for self-employed, deduction may not exceed individual’s net income (without regard to this deduction) from the trade or business in which the tips were earned

• Eligibility:

  • By Oct. 2, 2025, the IRS must publish a list of occupations that “customarily and regularly” received tips on or before Dec. 31, 2024. Examples likely include waiters, bartenders, hotel bellhops, casino dealers, hairdressers, and other similar service roles.
  • The deduction only applies to cash or card-based tips that you received from customers or through tip sharing in qualifying jobs. Service charges, regular wages or non-cash rewards are not considered qualified.
    • Adjusted gross income (AGI): $150,000 for single filers
    • $300,000 for married filing jointly

• Timeframe: applies to tax years 2025 through 2028

• Phaseout formula: the deduction is reduced by $100 for each $1,000 by which the taxpayer’s modified AGI exceeds the threshold.

• Employer reporting requirement: Tips must be reported to the employer and shown on Form W-2 or Form 1099 to qualify for the deduction.

Special focus: cash tips must be reported

Cash tips are often overlooked or underreported. Under this law, failure to report means loss of the deduction. Tips must be reported to the employer and included on statements furnished to the individual under IRC §6041(d)(3), §6041A(e)(3), §6050W(f)(2), or §6051(a)(18), or reported by the taxpayer on Form 4137.

Additional provisions

• Social Security number requirement: The taxpayer must include their Social Security number on the return to claim the deduction.
• Joint filers: Both spouses must file jointly to claim the deduction if married.
• Anti-abuse rules: The secretary is authorized to issue regulations to prevent reclassification of income as tips and to prevent abuse of the deduction.

What doesn’t count?

Not all payments received by service workers are eligible for the new tip income deduction. Tax professionals should be aware of the following exclusions:

• Unreported cash tips
• Tips not listed on the W-2 or Form 1099
• Service charges

Example: At a restaurant, Jamel’s bill includes a 15% service charge automatically added because he is part of a large group. He pays the total with his credit card. Even though it looks like a tip on the receipt, it’s a mandatory fee and not eligible for the tip income deduction. His server is Josh; therefore, Josh cannot count the 15% service fee as a tip.

There’s an income phaseout

The deduction is subject to an income-based phaseout. For every $1,000 (or fraction thereof) by which the taxpayer’s modified adjusted gross income MAGI exceeds $150,000 ($300,000 for joint filers), the deduction is reduced by $100.

Considerations for tax pros

1. Review client records

Advise clients in tip-based occupations to maintain accurate, contemporaneous records of all tips received and reported. Consistent tracking throughout the year is essential.

2. Confirm W-2 accuracy

Make sure client’s W-2s accurately reflect total reported tips. If clients have unreported tips , they must file Form 4137 to pay the appropriate FICA taxes. Remember, these unreported tips are not eligible for the deduction.

3. Withholding adjustments

Help clients estimate proper withholding or estimated quarterly tax payments based on the lower taxable income from the deduction.

4. Audit risk and compliance

Be alert to any attempts to reclassify wages as tips. Document legitimate tip income clearly to reduce audit risk.

5. Advise employers

Update payroll systems to ensure tips reported by employees are correctly captured. Businesses in the personal care sector may now benefit from an expanded FICA tip credit.

Final takeaway

The new tip deduction offers tax savings to lower- and middle-income workers, but only if they correctly report all tips to their employer. Tax professionals should ensure clients know the rules and follow them closely to benefit from this provision.

It’s often easier (and less expensive) for a business to classify its workers as independent contractors. However, the IRS is aware of this, and in recent years, has increased its emphasis on ensuring that employers are properly classifying their workers. Businesses that are misclassifying employees may be at an increased risk of audit.

Below, you’ll find a few of the top questions from a recent webinar on the topic and their accompanying answers. If you choose to attend the on-demand version of this webinar, you can access the full recording and the entire list of Q&As.   

Q: How quickly does the Form SS-8 get turned around, and how should an employer pay the employee or contractor in the interim?

A: The IRS states it can take up to six months for a determination. Importantly, this determination does not necessarily reduce any current or prior tax liability. If the employment status differs from what was expected, the IRS may require amended returns.

Q: How many years back can you file a Form SS-8?

A: The IRS will only issue determinations based on Form SS-8 for tax years that are still open. Typically, this period is the latter of three years from the date the original return was filed or two years from the date the tax was paid.

Q: Where can you find the Department of Labor’s independent contractor rules?

A: You can access the Department of Labor’s announcement of the new final rule, including links to the rule, an FAQ, and a small entity compliance guide.

Q: Can you appeal a Form SS-8 determination?

A: An IRS determination on Form SS-8 is final, and there is no formal appeal within the agency. However, if you disagree, you can provide additional information or highlight facts from your original submission that you believe were not adequately considered and request a reconsideration.

To learn more about classifying a taxpayer as employee or contractor, you can watch our on-demand webinar. NATP members can attend for free, depending on membership level! If you’re not an NATP member and want to learn more, join our completely free 30-day trial.

The IRS and Department of Labor (DOL) recently updated the memorandum of understanding (MOU) on identifying and reporting employee misclassifications to include a new streamlined process for identifying and reporting wrongful employee classifications. The streamlined process includes a decision tree to help investigators and auditors with the DOL’s Wage and Hour Division understand when to refer cases to the IRS’s Small Business/Self-Employed operating division as part of the Joint Worker Misclassification Initiative.

While taxpayers are generally responsible for any unpaid tax obligations to the IRS, preparers of employment tax returns or claims for refund may be liable for penalties under §6694. These penalties are imposed on preparers for understatements of tax due to unreasonable positions or willful or reckless conduct.

When will cases be referred to IRS?
The MOU includes information on a standardized referral form and a decision tree for assessing whether a matter should be referred to the IRS. According to the MOU, the DOL is to decide whether a case should be referred to the IRS based on the answers to the following questions:

• Was there a determination of employee status? The IRS only wants referrals that involve a determination of worker status.
• Is the business still in operation? The IRS does not want referrals for businesses that are no longer going concerns.
• Does the business have an average dollar volume (ADV) of more than $500,000? Employers with an ADV of more than $500,000 are likely to pay at least $25,000 a quarter in wages.
• Were Forms 1099 issued? If no Form 1099 was issued, the IRS will treat it as a “Tier 1” referral because the business can’t claim the protection of the safe harbor relating to federal employee status under §530 of the Revenue Act of 1978. Because the IRS will not need to devote resources to addressing the §530 issue, it will not need to spend as much time developing its case. The IRS will consider these instances to be a “prime lead” and afforded priority status due to the likelihood that any tax adjustments would be enhanced.
• Were workers in the same class treated inconsistently? If the business treated some workers in a class as employees and others in the same class as independent contractors, the IRS will also treat it as a Tier 1 referral. Businesses can’t claim protection under the §530 safe harbor provisions for issues related to worker status, and there is also the potential for the IRS to find enhanced noncompliance.

If a business treated all workers in the same class as independent contractors and issued Forms 1099, the IRS may still be interested in the referral as a Tier 2 lead because the business may be able to claim protection under the §530 safe harbor rules. As a practical matter, Tier 1 referrals will be given priority over Tier 2 referrals.

Who is eligible for §530’s safe harbor?
Section 530 is a relief provision that terminates a taxpayer’s liability for employment taxes for individuals not treated as employees if the following three requirements are met:

• Reporting consistency: The taxpayer must have filed the information returns that are consistent with its treatment of a worker as a non-employee. For example, an employer claiming a worker as an independent contractor would need to have filed a Form 1099.
• Substantive consistency: A taxpayer who treated the worker, or a worker holding a substantially similar position, was treated as an employee at any time after Dec. 31, 1977, the taxpayer can’t claim relief under §530.
• Reasonable basis: The taxpayer must have reasonably relied on one of the following at the time employment decisions were being made for the period at issue:
  • Prior audit
  • Judicial precedent
  • Industry practice

The relief provided under §530 does not apply to the determination of whether a worker was an independent contractor. Instead, it provides relief from employment tax liabilities of the employer, regardless of whether its workers were properly classified.

If you need additional information on how to properly classify workers and independent contractors or how to correct worker misclassifications, check out our on-demand webinar: Classifying a Taxpayer’s Employment Status.