Proposed Regulations: The IRS Guides Emploers in OBBBA’s No Tax on Tips

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For many years, income in the form of tips has been fully taxable to employees, meaning that tips were subject to federal income tax as well as Social Security and Medicare taxes. However, the One Big Beautiful Bill Act (“OBBBA”) signed in July 2025 changed the taxability of tips by creating a new above-the-line deduction for “qualified tips.” In accordance with the OBBBA, for tax years 2025 through 2028, certain tip income (and overtime pay) may be deducted from gross income for federal income tax purposes. In effect, there is “no tax on tips” or “qualified overtime compensation,” subject to limits and eligibility rules. However, the OBBBA left many specifics to the “(IRS”) and the Department of Treasury (“Treasury”), including implementing definitions and constraints. Therefore, in September 2025, the IRS and Treasury published proposed regulations (also referred to as a “Notice of Proposed Rulemaking” or “NPRM”) that address the temporary federal income tax deduction relating to tips.

Key Takeaways

Although “no tax on tips” is a welcomed change for customarily tipped employees, it is important to understand the constraints of this change as the NPRM brings its own set of challenges for employers.

1. Effective date. This is not a permanent exclusion, nor does it affect payroll taxes. In accordance with the OBBBA, for tax years 2025 through 2028. After 2028, if Congress does not extend this exclusion, tip income will revert to full taxation.
2. Qualified tips. To qualify for the deduction, the tip paid “[must be] paid voluntarily without any consequence in the event of nonpayment, is not subject of negotiation, and is determined by the payor.” The tip payment must be given by the customer or payor in cash, check, debit cards, or other equivalents; however, digital assets and non-cash items, such as event tickets and meals, are excluded. While tip pooling/sharing is allowed, it should be voluntary, properly documented with the split tips reported to the IRS. In addition, the IRS specified payments that are not “qualified tips.” For instance, tips that are automatically added by the establishment do not qualify unless the customer or payor has an express permission to modify or reject such mandatory gratuities without consequences. Tips tied to illegal activities as well as tips in the field of health, law, accounting, and financial services, and tips involving the performance of services that consist of investing and investment management, trading, or dealing in securities are also excluded.
3. Income limit phase-out and reporting. High-income taxpayers may have their exclusions reduced or eliminated. There is a $25,000 cap on tips per return, which applies whether filed individually or jointly. This amount is reduced by $100 for each $1,000 by which the taxpayer’s modified adjusted gross income exceeds $150,000 ($300,000 in the case of a joint return). Tips must be reported on statements furnished to the individual as required under various provisions of the Internal Revenue Code (e., Form W-2, Form 1099-NEC, etc.) or otherwise reported by the taxpayer on Form 4137 (Social Security and Medicare Tax on Unreported Tip Income).
4. Occupational restrictions. Only tips from qualifying occupations count, which are such occupations that “customarily and regularly receive tips” on or before December 31, 2024. In other words, an employee can deduct tips only if his or her occupation is on the list of occupations included in the NPRM. Servers, bartenders, taxi drivers, valets, home cleaners are just a few examples of such tipped occupations. Each is assigned a three-digit code referred to as “Treasury Tipped Occupation Code”). Otherwise, the deduction does not apply.
5. State taxes. Some states do not recognize the exclusion of tip income; thus, some state tax liability may remain unchanged.

Employer Impact

Although employees in tip-intensive industries are celebrating this change, this temporary exclusion may decrease tax revenues. Furthermore, critics are wary that, practically, this new policy of “no tax on tips” may encourage employers to decrease base wages and rely more heavily on tipping, which, in turn, could also lead to shifts in tipping culture and expectations.

These new rules also bring significant operational and compliance implications for employers, especially service-based industries where tips are more prevalent (i.e., restaurants, salons, hospitality, etc.). For 2025, in the absence of final regulations, employers may use reasonable approximation methods for segregating qualified tips and overtime amounts. As such, employers may need to revisit (and possibly revise) tipping practices and classification of employees. Accordingly, payroll and accounting systems will need to track, segregate, and report tip income and qualified overtime amounts separately as well as ensure proper reporting of information returns to employees indicating tipping amounts and occupation codes per the proposed regulations. However, before employees assume that tips are eligible for deduction, they must review the requirements above to determine whether the payments are qualified. This will likely increase complexity for both employers and employees.

Conclusion

The public may comment on the NPRM through October 23, 2025. Changes are likely to occur based on comments received and policy adjustments by the IRS. Furthermore, updated IRS forms are anticipated – for example, the IRS has indicated its intention to modify Forms W-2 reporting lines for the 2026 tax year. The NPRM also does not fully address the OBBBA’s overtime pay deduction rule, which seems likely to require separate coordination. Given the number of requirements set forth in the NPRM, both taxpayers and employers should closely monitor new developments and stay informed of the final regulations confirming or narrowing these rules.