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Understanding the New Above-the-Line Tax Deduction for Qualified Tips
The U.S. tax landscape continues to evolve with legislative updates, and one such recent change introduced in the “One Big Beautiful Bill Act” focuses on a new above-the-line tax deduction for qualified tips. This article delves into the historical and current aspects of tip taxation, highlighting the implications of this new deduction for workers in tipping-based occupations.
Prior Law on Tip Reporting and Employer Requirements - Historically, under U.S. tax law, employees receiving tips were required to report to their employer any tips amounting to $20 or more monthly from that employer. This reporting is done in writing to the employer by the 10th day of the subsequent month. Employers, in turn, are responsible for withholding both FICA (Social Security and Medicare) and income taxes on these reported tips. These amounts were then included on the employee's Form W-2 to be included as income on the employee’s income tax return. Failure to report tips could result in the IRS imposing a penalty on the employee, typically 50% of the employee's share of FICA taxes on the unreported tips.
Additionally, for larger food and beverage establishments—specifically those with customary tipping and ten or more employees—employers, for more than 40 years, have been required to allocate tips among employees. The allocation ensured that total reported tips by employees equaled at least 8% of the establishment’s gross sales. If reported tips fell short of this threshold, the employer was obligated to make allocations to cover the difference.
An interesting element of the prior law was the Employer Social Security Credit, an elective mechanism where food and beverage establishments could claim a credit for Social Security taxes paid on employee tips. Calculated using IRS Form 8846, the credit applied to the ‘excess’ employer social security tax, which was paid on the reported tips above certain minimum wage thresholds.
Introduction of the Above-the-Line Deduction for Qualified Tips - With the passage of the One Big Beautiful Bill Act, workers in specified tip-based professions gain a significant new tax benefit: an above-the-line deduction of up to $25,000 for qualified tips. However, the provision is temporary and is only available for 2025 through 2028. The $25,000 cap is on a per tax return basis, regardless of the filing status, not an individual basis. This means that no matter the filing status, the annual deduction limit remains at $25,000 for the tax return.
Above-the-Line Deductions - These deductions are subtracted from gross income to determine adjusted gross income (AGI). Thus, they can be advantageous as they reduce taxable income regardless of whether a taxpayer opts for the standard deduction or itemizes deductions. Such deductions can also influence the eligibility for other tax benefits which have AGI limitations. Note that while qualified tips up to the limit are now income tax free, employees’ tips are still subject to FICA withholding and self-employed recipients of tips may still need to pay self-employment tax on them.
Qualified Tips Definition - For tips to qualify for this deduction, they must be:
o Given voluntarily,
o Not subject to any consequence for non-payment,
o Are not negotiable, and the amount is determined by the payer.
o The trade or business receiving the tip is not a specified trade or business under Sec 199A(d)(2) and,
o Such other requirements established by future regulations.
This provision applies to both W-2 employees and independent contractors who might receive tips via various forms like 1099-K or 1099-NEC, provided the occupation is recognized as eligible by the Treasury Department. A list of qualifying professions is supposed to be published by the government by early October, 2025.Tips in Business Operations (Self-Employment):
o Inclusion in Business Income: Tips earned in the course of an individual’s self-employed business activities must be included as part of the business’s gross income.
o Deductive Eligibility: The self-employed individual’s tips are also eligible for a tip deduction under the established limits ($25,000 maximum per year) and provided the business in which the tips are received qualifies (see next). However, if the taxpayer’s business deductions exceed the business’ gross income, including the tips, the tip deduction will be limited.When the Deduction is Unavailable - There are several restrictions on when this deduction can be taken:
1. Specified Service Trades or Businesses: The tax code differentiates between general business trades and specified service trades or businesses as defined under Section 199A(d)(2). Workers in specified service industries, such as health care, law, accounting, and consulting, among others, are ineligible for this deduction. These trades often rely heavily on the reputation or skill of their employees, which can include many professions beyond food and beverage.
2. Income Based Reduction - Further complicating the computation of this new deduction is the income-based reduction rule. For individuals with an adjusted gross income (AGI) exceeding $150,000 or $300,000 for joint filers, the deduction is incrementally reduced by $100 for every $1,000 over the AGI threshold.
3. Filing Status – Taxpayers who are married must file a joint return to claim this deduction.
4. Social Security Number (SSN) Requirement: A valid, work-eligible SSN is mandatory for anyone claiming the deduction, ensuring compliance and enabling validation of income against IRS records.Expanded FICA Tip Tax Credit - Another noteworthy amendment in the One Big Beautiful Bill Act is the expansion of the FICA tip tax credit. Traditionally limited to food and beverage establishments, it now covers beauty services. This broadening allows hair care, nail services, esthetics, and spa treatment businesses to claim a credit for a part of the Social Security taxes paid on employee tips. This expansion acknowledges the prevalence of tipping in these additional service industries, addressing an oversight in the prior law.
The advent of the above-the-line deduction for qualified tips in the new legislation is a landmark shift, recognizing the unique nature of tip income in today’s economy. By reducing taxable income directly from AGI, it affords significant tax relief to eligible workers. However, nuances around eligible professions and the exclusion of high earners complicate the landscape, emphasizing the need for individuals in these professions to consult with tax professionals to maximize their benefits under this new rule. Moreover, the broadened FICA tip credit further supports employers in sectors historically overlooked, marking a progressive step in tax policy adaptation to modern occupational realities.
If you are a tipped employee or self-employed individual or an employer wanting to know how the recent tax law changes will affect your circumstances, please contact this office.
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