By Charles Peery, CPA | Business Tax Practice Leader
Significant IRS changes taking effect in 2026 will impact how businesses track, report, and substantiate employee tips. These new rules under Internal Revenue Code section 224 also affect how eligible employees may claim a federal income tax deduction for qualified tips. Taking steps now to understand and prepare for these requirements can help ensure compliance and avoid surprises when 2026 payroll reporting begins. Continue reading for detailed information.
Key Points:
- Only “qualified tips” are deductible by employees under section 224.
- You must separately report cash tips and employee occupations on 2026 Forms W-2.
- Payroll and point-of-sale (POS) systems must be configured to capture and report tips in accordance with the new requirements.
- Not all tips are “qualified”; mandatory service charges and tips from certain businesses are excluded.
- Married employees must file jointly to claim the deduction, and the deduction is capped at $25,000 per return, regardless of filing status.
Below, we outline the new requirements, explain how to distinguish between allowable and non-allowable tips, and highlight steps you can take now to prepare your payroll and reporting systems. Please contact us with any questions or if you would like assistance updating your payroll and recordkeeping processes.
Detailed Guidance for 2026 Implementation
Understanding “Qualified Tips” under Section 224
Definition of Qualified Tips:
- Qualified tips are cash tips received by an individual in an occupation that customarily and regularly received tips on or before December 31, 2024, as listed in IRS guidance (e.g., wait staff, bartenders, bussers, etc.).
- “Cash tips” include tips paid in cash, by check, credit/debit card, gift card, or other cash-equivalent forms, and, for employees, tips received through tip-sharing arrangements.
- To be qualified, tips must be:
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- Paid voluntarily by the customer, without compulsion or negotiation.
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- Not a mandatory service charge or automatic gratuity unless the customer can freely modify or decline the amount.
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- Not received in the course of a specified service trade or business (SSTB) as defined in section 199A(d)(2) (e.g., law, health, performing arts, etc.).
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- Not received from an employer or payor in which the employee has an ownership interest or is employed by the payor of the tip.
Non-allowable (Non-qualified) Tips:
- Mandatory service charges (e.g., automatic 18% gratuity for large parties).
- Tips received in the course of an SSTB.
- Tips paid by the employer or by a business in which the employee has an ownership interest.
- Tips received for illegal services or activities.
Examples:
- A customer leaves a cash tip on the table after a meal: qualified tip.
- A customer pays a bill with an automatic 18% gratuity added, with no option to change or remove it: not a qualified tip.
- A bartender receives a tip from a customer at a restaurant (not an SSTB): qualified tip.
- A singer employed by a theater company (an SSTB) receives tips: not a qualified tip.
2026 Tip Reporting Requirements
Form W-2 Changes:
- For 2026, employers must separately report:
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- The total amount of cash tips reported by the employee under section 6053(a).
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- The employee’s occupation (as defined in the IRS list of occupations that customarily and regularly received tips).
- This information must be included in new or revised boxes on Form W-2.
Payroll and POS System Setup:
- Configure payroll and POS systems to:
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- Track and record all cash tips, including those paid by credit/debit card and through tip-sharing arrangements.
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- Record the occupation of each tipped employee, using the IRS’s occupation codes.
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- Distinguish between voluntary tips and mandatory service charges.
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- Generate reports that separately account for qualified tips for each employee.
- Ensure that tip-outs (amounts distributed to support staff from pooled tips) are properly tracked and reported.
Recordkeeping:
- Maintain contemporaneous records of all tips received and reported by employees.
- Retain documentation supporting the classification of tips as qualified or non-qualified.
- Keep records of employee occupations and any changes in roles.
Steps to Ensure Compliance and Readiness
A. Review and Update Policies
- Update employee handbooks and training materials to reflect the new tip reporting and deduction rules.
- Communicate the importance of accurate tip reporting to all staff.
B. System Configuration
- Work with your payroll provider and POS vendor to ensure systems are updated for 2026 requirements.
- Test the system to confirm that it captures and reports tips and occupations as required.
C. Documentation and Substantiation
- Require employees to submit regular tip reports (e.g., daily, weekly, or monthly).
- Retain all tip reports, payroll records, and supporting documentation for at least three years.
D. Monitor and Audit
- Periodically review tip reporting for accuracy and completeness.
- Audit tip records to ensure that only qualified tips are being reported as such.
E. Stay Informed
- Monitor IRS guidance for any updates or clarifications on section 224 and tip reporting.
- Subscribe to IRS updates or consult with your tax advisor regularly.
F. Employee Education
- Hold training sessions for employees on the new rules.
- Provide examples of qualified and non-qualified tips.
- Explain the impact of the deduction cap and the joint filing requirement for married employees.
G. Prepare for State Law Differences
- Be aware that state tax treatment of tips may differ from federal rules; consult with your state tax advisor as needed.
Step for Employee Updates
A. Update form W-4
- If you do not update your Form W-4, your federal income tax withholding will not reflect this new deduction. This means you may have more tax withheld from your paychecks than necessary, resulting in a larger refund at tax time but less take-home pay throughout the year.
- Estimate Your Qualified Tips for 2026:
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- Qualified tips are voluntary cash or charged tips you receive from customers, including those received through tip-sharing arrangements. Mandatory service charges added to bills are not qualified tips.
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- Only tips received in eligible occupations (as listed by the IRS) qualify. Most restaurant positions are included, but check the IRS list or ask HR if you are unsure.
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- The maximum deduction is $25,000 per year, and the deduction phases out for individuals with modified adjusted gross income over $150,000 ($300,000 for joint filers).
- Complete the Deductions Worksheet:
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- Use the Deductions Worksheet provided with Form W-4 (Step 4(b)) to estimate your total qualified tips for the year, up to $25,000.
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- Enter your estimated qualified tips deduction on line 1a of the worksheet. Add any other deductions you expect to claim and follow the worksheet instructions to calculate the total amount to enter in Step 4(b) of Form W-4.
- Submit the Updated Form W-4:
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- Complete a new 2026 Form W-4, entering your estimated deduction in Step 4(b).
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- Submit the updated form to your employer as soon as possible to ensure your withholding is adjusted for the remainder of the year.
B. Proactive Tax Planning
- Work with your tax advisor to ensure correct withholding.
- Update W-4 for any additional changes.
With these changes approaching, now is the time to review your payroll processes and ensure your systems and documentation are ready for 2026. ATA can assist with system reviews, compliance planning, and employee guidance related to the new tip reporting and deduction rules. We encourage you to reach out with questions or to schedule time to discuss next steps.
