As reported by Forbes, the Senate has unanimously passed the “No Tax on Tips Act” in a unanimous vote. This bipartisan piece of legislation now heads to Trump’s desk to be signed into law. This article highlights three key takeaways from the significant tax law change.
1. Most Tip-Based Taxpayers Will Pay No Tax On Some Tips
The No Tax On Tips Act provides a tax deduction for cash tip wages reported to employers. However, there are key limitations. First, the amount that can be deducted is capped at $25,000. Thus, the bill actually means that some (rather than no taxes) will be paid on tips. Second, the deduction will not apply to taxpayers that earn more than $160,000. Third, the taxpayers who can take this deduction will be limited to certain occupations, which, according to The Guardian, will be provided by the US Department of Treasury within 90 days.
The aim of these limitations is to limit loopholes. As I reported in Poole Thought Leadership, absent any limitations, high-earning individuals can game the system for their benefit. For instance, if the CEO of a company were to structure his or her’s entire income as a tip, then, absent any limitations, he or she would be able to lower their tax liability considerably, even though the bill is not aimed at them. Given the limitations, the CEO would not be permitted any deduction because their occupation is not expected to be on the permitted list. The limitations also limit the wealthiest taxpayers from taking this deduction.
Lastly, many tip-based taxpayers will not benefit from this bill because they make too little. With the 2025 standard deduction set at $15,000 for an individual taxpayer, Yahoo!News reports that 37% of tip-based taxpayers already pay no federal income taxes due to their taxable income already being less than the standard deduction.
2. Tip Income Can Still Be Subject To State Income Taxes
Once this bill is passed, according to the Institute on Taxation and Economic Policy, states must conform their income taxes to the federal level for the workers to be exempt from state income taxes. This means that state legislators must begin to act soon to limit the tax liability on tip income for affected employees.
For instance, if a taxpayer were to be earning $100,000 in tip income, the employee’s income after the deduction at the federal level would be $75,000. However, absent any conformity, the income in the eyes of the state where they reside would be $100,000. As some states tax income of $100,000 as high as 9.30%, the taxpayer can still be subject to significant state tax burdens. States like North Carolina are already moving forward with these actions. Thus, tip-based taxpayers will need to watch whether their state allows this deduction closely.
3. The No Tax On Tips Act Provides A Tax Deduction Rather Than An Income Exclusion
While it is required under law for tip-based taxpayers to report their tip earnings for tax purposes, they also receive benefits for having these funds reported as income. For instance, if a tip-based employee were to be trying to get a loan for a house or a vehicle, they would need to have documented income to support the lending decision. Furthermore, many taxpayers set aside some of this income to contribute to Social Security or other retirement accounts like IRAs.
Early on in the legislative process for the No Tax On Tips Act, it was unclear how exactly the tips would not be subject to taxation. Specifically, the bill could have exempted the taxation from income or the bill could provide a deduction from income. While both would have resulted in the same effect on the taxpayer’s tax liability, a key nuance is that exempted income (depending on how it was exempted) could affect how external entities perceive it and would potentially affect the taxpayer’s ability to contribute to retirement. According to Kiplinger, the version of the bill passed by the Senate sided with the latter, protecting the tip-based taxpayer’s ability to contribute the full amount to Social Security.
Read the full article here