Before the “no tax on tips” provision was tucked into the One Big Beautiful Bill Act, it was a 2024 campaign promise offering tax relief to workers. But in reality, complying with the new law poses a relatively complex challenge for tax preparers, employers and employees in industries with tips or what some call “variable compensation.”
The new law on tips in the OBBBA signed into law last year has ushered in one of the most significant payroll reporting changes in more than a decade, according to Tom O’Saben, director of tax content and government relations at the National Association of Tax Professionals.
It poses a considerable operational burden for payroll system managers who must now tally and report much more granular data on tips that are often paid in cash and not reported. It also seeks to impose order in a historically disorderly area of tax reporting.
“Tips have always been a very vague and messy area of tax,” O’Saben said, noting that there are always questions around whether people are reporting their full tips. “In some respects, it’s almost like an enticement for people to come clean and start reporting their tips.”
In order to comply with the law, employers will need to work with employees to record both cash tips and tips paid through third party systems. Verifying such information for total tips should be easier than in the past, as an increasing portion of gratuities are paid through credit cards and other payment services.
The new law allows eligible workers to deduct up to $25,000 in qualified tips from their income for the tax years 2025 through 2028, according to IRS guidance. It’s important to understand that it’s only a federal and not a state tax deduction, and as such doesn’t completely rule out taxes on tips, O’Saben said.
This year is a transition year. The Internal Revenue Service announced in August that there would be no changes to the W-2 forms in an attempt to avoid disruptions and “give the IRS, business and tax professionals enough time to implement the changes.”
The IRS guidance has also granted employers penalty relief for the 2025 tax year related to providing correct information on qualified tips, and grants employees and employers “transition relief” until Jan. 1 of the first calendar year after final rules are issued to determine if they fall under a category eligible for exemptions, CFO Dive sister publication HR Dive reported.
O’Saben said new fields are expected to be added to 2026 W-2 forms, with a category identifying employees who are in approved tip categories like restaurants, bars, hotels, salons and delivery services. Two new Box 12 codes that would require information on total qualified tips and total qualified overtime compensation are also expected.
For now, his advice for payroll preparers is not to ignore the new rules and to make a “best effort” to collect and document your system. “Document, document, document, that would be my suggestion to employers,” O’Saben said. “Document the methods you use and maybe what your payroll provider suggested.”
