Automatic gratuities may not be eligible for new Trump tax break on tips

USA Today

3 days ago

I don't like to think of myself as a bad tipper.
Yet, I handed over what had to be a head-scratching tip about "no taxes on tips" to a waiter in Detroit one Saturday night in July. Did he realize that the automatic 20% tip on the bill at Andiamo's Detroit Riverfront could mean that he wouldn't get a tax break?
We've heard plenty of "no tax on tips" talk this summer as President Donald Trump's "big, beautiful bill" worked its way through Congress to ultimately be signed into law July 4.
Still, not much has been in the headlines about one possible trigger for tax-time indigestion involving tip income when a restaurant has an automatic gratuity on the bill.
My waiter, though, wasn't about to engage in tax tips. He was waiting for his real one. He cut the conversation short by saying that "no tax on tips" will kick into gear next year so it doesn't matter now. He was only partly correct.
What does 'no tax on tips' mean?
The new, special tax break on tips is retroactive and applies to eligible tip income earned in all of 2025. Waiters, hairstylists and others who regularly receive tips this year will have to wait until next year to claim a deduction for tip income reported on their tax returns when they file 2025 returns.
The special deduction can save plenty of workers good money whether they itemize their deductions or claim the standard deduction, as most people do these days. The tax break runs from 2025 through 2028.
Employers still are required to withhold taxes from each paycheck for Social Security and Medicare, which are referred to as FICA or payroll taxes.
About 6 million workers report tipped wages, according to the White House, including "waitresses and waiters, rideshare and food delivery drivers, taxi drivers, beauticians, hairdressers."
By contrast, the Budget Lab at Yale University estimates that roughly 4 million people worked in occupations where workers regularly received tips in 2023 — or about 2.5% of all employment.
Tipped workers tend to be younger than the rest of the U.S. workforce, with a median age of 31 years old, according to Budget Lab. One third of tipped workers, according to the study, are younger than 25.
A sizable group had such low incomes — some 37% —that they faced no federal income tax in 2022, even before accounting for tax credits, such as the earned income tax credit, according to Budget Lab.
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The IRS might treat 20% automatic tip differently
Like many of the new tax breaks packed into the big, beautiful bill that I've written about this summer, some rules will trigger situations where "no tax on tips" still translates into a tax bill. Nothing is as simple as the catchphrase.
The 2024 presidential race will be remembered for Trump's promise of "no taxes on tips." Eliminating all taxes on tips, though, isn't on the menu when you peruse the big bill.
Simply put, some complex rules will determine what tips will still be taxed and what tips won't be taxed under a new deduction for tipped income. And tax professionals remain on edge now, waiting for the Internal Revenue Service to issue more guidance.
Waiters and others who benefit from automatic gratuities of 20% or more could be in for quite a shock, according to some early analysis.
Tom O'Saben, enrolled agent and director of tax content and government relations for the National Association of Tax Professionals, and other tax experts are raising red flags about "mandatory tips."
"When a restaurant automatically adds a 20% service charge, that amount is considered a mandatory service fee, not a tip under the IRS's rules — and not eligible for the new tip income tax deduction," O'Saben told the Detroit Free Press, part of the USA TODAY Network.
The IRS, he said, takes the position that a tip must be voluntary, not required by the employer or establishment, paid freely by the customer and given directly or indirectly to the worker to qualify for the tax break.
It's likely, O'Saben said, that servers will still be required to pay taxes on automatic gratuities.
Again, we have yet to see whether the IRS offers guidance that specifically excludes mandatory service fees from being eligible for the tax deduction for tip income. But tax professionals see the writing on the wall.
Janet Holtzblatt, senior fellow at the Urban Institute-Brookings Tax Policy Center, shares a similar viewpoint about potential exclusions.
According to the new tax act, Holtzblatt said, tips that qualify for a tax break involve amounts that are 'paid voluntarily without any consequence in the event of nonpayment, is not the subject of negotiation, and is determined by the payor.'
These simple words, "'voluntarily and determined by the payor,' may make a big difference in paychecks," Holtzblatt wrote in a July 24 blog that urged quick guidance from the IRS to clarify key details that Congress left unresolved.
"Workers might be very disappointed if the IRS relies on the same guidance used for the existing credit for employers' share of Social Security taxes paid on tips," she said.
She noted that it has been estimated that 16% of restaurants regularly add a service charge to the bill, and 54% sometimes do, such as for larger groups of six or more people at a table.
The issue is particularly of concern, Holtzblatt said, in areas, like Washington, D.C., where 20% service fees are increasingly part of bills being handed to consumers.
There's another wrinkle to the treatment of service fees, she said. While they look like a gratuity, the service fee may also cover part of the owner's nonlabor costs.
Restaurants wait for more IRS guidance
Restaurants find themselves still navigating the new tax rules and waiting for IRS guidance.
Peter Gray, chief financial officer for the Joe Vicari Restaurant Group, which includes Andiamo Detroit Riverfront, told the Detroit Free Press that the tax laws surrounding tips and tip credits are still very new, and the rules and regulations are still developing.
"We are working closely with our team members and payroll company to ensure everybody is educated properly on these new tax laws and how they need to be handled and reported," Gray said in a statement to the Free Press.
"This will also require some additional guidance from the IRS on these new laws so we can ensure we are handling things properly and making decisions that are best suited for our company and team members."
Beverly Hills Grill in Oakland County, which adds an automatic 20% gratuity onto its bills, plans to continue the practice right now, but owner Raphael Michael is "reviewing all the guidelines with his CPA and financial advisers," according to spokesperson Sari Cicurel.
According to the restaurant's certified public accountant, Cicurel said, the automatic gratuity of 20% is not mandatory and "no tax on tips" would apply to the restaurant's employees.
The IRS fact sheet listed on its website says "no tax on tips" applies to qualified tips that are "voluntary cash or charged tips received from customers or through tip sharing."
These tips, the IRS stated, "are reported on a Form W-2, Form 1099, or other specified statement furnished to the individual or reported directly by the individual on Form 4137."
During the 2025 transition, O'Saben said, the IRS will permit reasonable estimates for the deduction period. But, he said, the IRS is going to require that companies ultimately update their payroll systems and earnings codes.
Some changes could be ahead for 'mandatory' tips
Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting in Riverwoods, Illinois, said he'd expect that restaurants would need to shift away from mandatory tips or service fees for employees to qualify for the deduction.
"The provision requires that the tip be 'voluntarily given,' which would appear to exclude automatic add-ons," Luscombe said.
Scott Klein, senior manager for tax policy and advocacy with the American Institute of CPAs, throws another wrinkle into the mix. Klein agrees the IRS will likely view an automatic gratuity as a tip that is not voluntary and does not qualify for a tax break.
"However, any discretionary amount given as a tip in addition to the service charge would be considered a qualified tip," Klein said.
Add another $5 on top of a $20 automatic gratuity, for example, and he'd say that extra $5 should be eligible for the tax deduction.
"This tip provision could be a reason for restaurants to reapproach the decision to charge an automatic gratuity," Klein said.
The IRS will tell us more by October
By Oct. 2, the IRS is expected to release a list of "approved tip recipients" who could qualify for the "no tax on tips" tax deduction.
We're talking about a new tax deduction for those who work in jobs where cash tips are typically expected. The IRS will be looking at whether the workers "customarily and regularly" received tips before Jan. 1, 2025, to prevent abuse, such as someone suddenly classifying regular wages as tips.
"The approved list may not extend far beyond the restaurant, beverage, hospitality and hair care industries specifically mentioned in the legislation," Luscombe warned.
Yet, Klein said consumers are experiencing a growing prevalence of tipping across industries so some additional industries might be included in the IRS list.
Given some of the uncertainties now, Klein said, employers and employees should keep an accurate account of tips received so that they can account for them if the new federal income tax deduction allows them a tax break.
Remember, employees can deduct only tips that are properly reported to employers and reflected on tax statements. (And, yes, some did not report all of their tip money, especially what was received in cash, to the IRS over the years.)
Workers still must report all tips to their employers if they total $20 or more in a single month, according to the Budget Lab.
Employers, Klein said, should continue to track tips, and should identify and categorize automatic and voluntary gratuities separately as they await more guidance.
Tipped restaurant workers already are required to report tips earned during a shift and tips are already listed on a separate line on their annual W-2 form and that's not expected to change, according to the National Restaurant Association.
Klein said he expects the IRS to give more details on how the agency plans to implement the deduction on Form 1040. The IRS is expected to update withholding procedures.
He'd expect the creation of a worksheet for the "no tax on tips" deduction that will likely include a modified adjusted gross income calculator for the tip deduction phaseout and occupation codes for tip eligibility.
How much in tips could be tax free?
The "no tax on tips" break could disappoint some who generate a great deal of money in tips during a year — especially if both spouses work in such jobs.
The new law appears to stipulate that the maximum annual deduction for tip income is $25,000 per tax return — not $25,000 for each employee listed on a joint return, according to how O'Saben and Luscombe read the tax bill. We will need more clarity from the IRS guidance.
For reference, the maximum deduction for the new tax break on overtime pay is $12,500 for singles and $25,000 for joint filers each year.
Married people who file separately — even if one earned $20,000 in tips — are not permitted to claim the "no tax on tips" deduction at all. They would owe taxes on all their tip income.
What's straightforward:
Will a $25,000 limit for the deduction cover everyone's tips for the year?
O'Saben said part-time or lower-volume workers might see that all or most of their tips will qualify for a tax break at the $25,000 threshold or less.
According to an example give by the Bipartisan Policy Center, a single taxpayer earning $50,000 — including $5,000 in tips — could save $600 with the new tax deduction on tip income.
But some high-volume servers, servers at high-end restaurants, those working in luxury hospitality, and casino workers are the most likely to earn a great deal of tip income. While many might still save thousands of dollars in taxes, experts say many of these taxpayers would owe taxes on tip income above the $25,000 threshold.
Luscombe noted that the Congressional Research Service issued an "In Focus" on July 31, 2024, that estimated the median tip income was $2,600 each year while the average tips income was $6,000 per year, indicating that there are a few tip recipients who receive a large amount in tips, raising the average.
But some won't get any tax break at all — if they had so little income that they're not paying taxes.
Almost any single taxpayer making less than $15,750 and married couples making less than $31,500 in 2025, according to the Bipartisan Policy Center, will pay nothing in federal income taxes already due to taking the standard deduction.
As a result, an additional tax deduction on tip income tips will not benefit those taxpayers because it does nothing to reduce their tax liability further.
The White House states online that workers on average will receive about $1,300 more from "no tax on tips" each year that the tax break remains in place.
We're dealing with a lot to digest here.
Maybe it doesn't hurt to think of these tax breaks like tiramisu. The Italian dessert never quite tastes the same no matter where you order it. Ditto for "no tax on tips." How much this tax break pulls you up will depend on where you work, what kind of tips you get and more.
Contact personal finance columnist Susan Tompor: [e-mail]. Follow her on X @tompor.