No tax on tips is here. What employers need to know for 2026 | Expert Opinion

“No tax on tips” sounds simple. For employers, it isn’t.

Starting in 2025, employees who received tipped income can now take a deduction for this amount on their individual tax returns, which reduces their taxable income and taxes owed.

The benefits are obvious, but some of the rules are less so. Here’s what to know.

The deduction is capped at $25,000 per return, even for married couples filing jointly. It phases out for joint filers with $300,000 or more annual income and $150,000 for other taxpayers.

Tips claimed must be voluntary. If you’re charging your customers a mandatory “service charge” and then disbursing the amount collected to your employees, that amount is not eligible as tipped income for purposes of the tax deduction.

Put simply, a mandatory service charge and a voluntary tip are not interchangeable, said Shanita Jones, a certified public accountant in Philadelphia.

“Calling a charge a gratuity on the receipt doesn’t automatically make it a tip for tax purposes,” she said. “Owners should verify that their point-of-sale system, bookkeeping records, and payroll system distinguish voluntary tips from mandatory charges.”

Eligible employees must work in one of the more than 70 occupations the IRS has designated as traditionally tipped. These include servers, bartenders, hairstylists, makeup artists, hotel workers, rideshare drivers, and personal trainers. Occupations such as accountants, tax preparers, and most legal professionals aren’t on the IRS list.

Self-employed workers can also take advantage of the tips deduction, but the deduction can’t exceed the net income of their trade or business.

The “no tax on tips” deduction is applied only at the federal level. Neither Pennsylvania nor New Jersey makes this deduction available when calculating state income taxes owed.

The two states do have a reciprocal agreement so that if a worker who lives in Pennsylvania earns tipped income at their job in New Jersey, they’re still taxed at Pennsylvania rates.

Also, tips are not exempt from all kinds of federal taxes. Employees must still pay the taxes for Social Security and Medicare.

“Before telling employees their tips are tax-free, make sure you can answer: free from which tax?” Jones said. “The distinction matters because employees may make spending decisions based on what they believe they will keep.”

Employers must also match the FICA and Medicare payments.

But restaurants and certain food service businesses may qualify for the federal FICA Tip Credit, said Adrienne Straccione, a partner at accounting and advisory firm Wouch Maloney in Philadelphia.

This credit is different from the employee tip deduction. It was expanded as part of last year’s tax legislation to include qualifying barbering, hair care, nail care, esthetics, and body and spa treatment businesses. The credit is not a deduction — it is taken against taxes owed and if it exceeds what’s owed it can generally be carried back one year and forward up to 20 years.

“This expansion can potentially provide a valuable tax benefit on certain employer-related taxes for more employers with tipped workers,” she said.

If you’re an employer, you need to be familiar with the reporting required, Jones said, because no tax on tips does not mean “no reporting of tips.”

“A tax break for an employee does not erase an employer’s responsibilities,” she said. “Business owners should not stop recording tips or change their payroll practices simply because they hear the phrase “tax-free.”

For 2025, employers received transition relief because Forms W-2 and 1099 had not yet been redesigned to separately report the information needed for the new deduction. That’s different for 2026. Employers now report cash tips on Form W-2 using Box 12, Code TP, and identify the worker’s qualifying occupation in Box 14b.

Employers should expect “greater scrutiny of how tips are tracked,” categorized, and reported, Straccione said.

“Businesses need to understand what code section your employees fall under for the Treasury Tipped Occupation Codes,” she said. “Failure to comply with the new W-2 reporting standards can result in penalties.”

It’s important that your employees take advantage of the deduction during the course of the year by reducing the amount of federal taxes they’re having withheld from their paychecks. We’ve been recommending to our clients that they help their employees revise their W-4 withholding form to reduce the amount of tax taken from their paycheck. This will leave them with more money left over throughout the year, rather than waiting for a refund from the government.

Both Jones and Straccione are advising clients to establish written processes for reporting all tips, documenting the distributions, and getting that information into their payroll systems.

“Cash tips should not disappear from the records simply because they never passed through the business’s card processor,” Jones said. She advises that businesses review their process with their accountant and payroll provider, confirm the applicable year’s reporting requirements, and reconcile records regularly.

“Tax season should not be the first time you discover that your sales system, payroll records, and books tell three different stories.”

The no-tax-on-tips deduction is good for both employees and employers. Obviously, the employee gets to save money. But the employer, because their workers are effectively getting paid a little more by the tax savings, may feel less pressure to increase wages this year.

The deduction won’t last forever. It’s scheduled to expire after the 2028 tax year, unless Congress extends it.