The One Big Beautiful Bill Act (OBBBA) introduced a new federal income tax benefit that is often referred to as “no tax on tips.” While the phrase is catchy, the rule is more precise and more limited than the headline suggests. This article explains how the rule works, what qualifies, and what does not.
What the Law Actually Does
Under OBBBA, eligible workers may claim a federal income tax deduction of up to $25,000 per year for qualified tip income. The deduction applies for tax years 2025 through 2028, unless extended by future legislation.
This is an above-the-line deduction, meaning it reduces adjusted gross income and is available even if the taxpayer does not itemize deductions.
Importantly, tip income is still reported on tax returns. The benefit is achieved through a deduction, not by excluding tips from income entirely.
What Counts as a Qualified Tip
Not all amounts labeled as “tips” qualify. For purposes of this deduction, qualified tips must meet all of the following conditions:
1. Voluntary payments from customers
Tips must be optional and determined by the customer.
Amounts that are required by the business do not qualify, even if described as gratuities.
2. Paid in cash or cash equivalents
Qualified tips include:
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Cash tips
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Credit card and debit card tips
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Tips paid through digital or app-based payment platforms
These forms of payment are treated as cash equivalents for tax purposes.
3. Properly reported income
Tips must be reported through standard tax reporting channels, such as Form W-2, Form 1099, or Form 4137, depending on how the worker is classified.
What Does Not Qualify
The following amounts are not eligible for the deduction:
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Mandatory service charges
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Automatic gratuities required by the establishment
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Tips imposed by employer policy
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Any required fee that the customer does not control
Even when these amounts are paid to employees and included in wages, they are treated as compensation rather than tips under the tax rules.
Income Limits Apply
The deduction is subject to income-based limitations. Taxpayers above certain income thresholds may see the deduction reduced or eliminated. As a result, the benefit is primarily aimed at lower- and middle-income workers in traditionally tipped roles.
Other Taxes Still Apply
The “no tax on tips” rule applies only to federal income tax.
The following still apply to tip income:
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Social Security and Medicare taxes
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Federal withholding requirements
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State and local income taxes, unless a state specifically adopts a similar rule
The law does not change employer payroll tax responsibilities or employee reporting obligations.
What This Means for Workers and Employers
For workers, this provision can reduce federal income tax liability, but only when tips are:
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Voluntary
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Paid in cash or cash equivalents
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Accurately reported
For employers, the key compliance issue is correct classification. Mandatory charges must be clearly separated from voluntary tips in payroll and accounting systems.
Bottom Line
The OBBBA “no tax on tips” provision is best understood as a temporary federal income tax deduction for voluntary, customer-paid tips received in cash or cash-equivalent form. It does not eliminate reporting requirements, does not apply to mandatory service charges, and does not remove payroll taxes.
Clear policies, accurate reporting, and proper classification are essential to ensure compliance and preserve the intended tax benefit.