“No Tax on Tips?” What That Really Means for Restaurant Owners
If you run a restaurant, bar, or brewery, you’ve probably heard about the new “No Tax on Tips” rule that took effect in 2025. It’s a huge win for your employees but it also adds a layer of responsibility for you as the employer. How you report and classify tips now determines whether both you and your team can fully benefit from the change.
Let’s break down what the new rule actually means, who qualifies, and why some restaurants could accidentally lose these benefits by switching to automatic gratuities.
What the “No Tax on Tips” Rule Actually Does
Starting in 2025, employees who earn tips as part of their regular job can exclude up to $25,000 of reported tip income from their federal taxable income each year through 2028. This deduction was introduced under the One Big, Beautiful Bill Act (OBBBA) to support tipped workers like servers, bartenders, and barbacks.
Here’s the key:
The deduction only applies to voluntary tips, NOT AUTOMATIC SERVICE CHARGES or MANDATORY GRATUITIES.
The IRS defines a tip as:
- A payment made voluntarily by the customer,
- Where the customer decides the amount, and
- The customer has the right to decide whether to pay it at all.
In contrast, automatic gratuities, such as 18% added to large party checks or catering events, are treated as wages. That means they are fully subject to payroll tax, withholding, and do not qualify for the “no tax on tips” deduction.
For restaurant owners, this distinction also affects your own tax benefits. You can still claim the FICA Tip Credit (Form 8846) on the employer portion of Social Security and Medicare taxes paid on reported tips, but only if those tips are properly categorized.
How Restaurants Should Track Tips to Stay Compliant
If you want to protect both your employees’ deduction and your FICA Tip Credit, make sure your systems can clearly separate tips from auto-gratuities.
Start with your POS system:
- Check that voluntary tips and service charges are recorded in different categories.
- If your POS lumps everything under one “tips” line, your payroll reports will misclassify them, and that’s a red flag for the IRS.
- Review your POS settings with your accountant or bookkeeper before year-end to confirm that your mappings align with the IRS definition of a tip.
Then, verify your payroll setup:
- Make sure that your payroll system treats voluntary tips as tip wages.
- Ensure automatic gratuity flows are reported as other wages, or gratuity wages, and are taxed accordingly.
- Do not rely solely on your software’s defaults, they usually don’t categorize it correctly. The IRS expects you, the restaurant owner, to be responsible for verifying accuracy before filing.
If these systems aren’t properly mapped, you risk overstating wages, under-reporting tips, and losing thousands in credits or deductions.
What If We Just Replace Tipping With Automatic Gratuities?
Some restaurants saw the “no tax on tips” rule and thought: “Let’s just switch to automatic gratuities on every check, it’ll be simpler.” Unfortunately, that approach can backfire badly.
Here’s why:
- Auto-gratuities are treated as wages. They’re subject to payroll taxes and withholding, INCREASING your employer tax burden.
- Employees lose the tip deduction. Auto-gratuities don’t count toward the $25,000 “no tax on tips” benefit.
- YOU LOSE the form 8846 FICA Tip tax credit. Since those amounts are now gratuity wages, you can’t recover the employer portion of FICA taxes on them.
In other words, turning all tips into automatic gratuities doesn’t save you time or money, it costs both. It removes your eligibility for one of the most valuable restaurant tax credits while reducing your team’s take-home benefits.
Instead, keep voluntary tipping. You can still use auto-gratuities for special cases like large parties or catering, but don’t make it your default. If you want more predictable payroll or fairer tip distribution, consider a tip pooling arrangement that meets IRS definitions for voluntary tips. Just avoid replacing tips with a service charge policy, those are treated as wages, which means they don’t qualify for the new “No Tax on Tips” deduction or the FICA Tip Credit.
What Restaurant Owners Should Do Now
If you haven’t already, take time before year-end to:
- Review your POS configuration to ensure it separates tips and auto-gratuities.
- Check that your payroll system records and taxes them correctly.
- Educate your managers and staff about the differences between tips and service charges.
- Confirm with your CPA that you’re claiming the FICA Tip Credit (Form 8846) on your business return.
Clean, accurate records not only keep you compliant but also protect your employees’ deductions and preserve your tax savings.
Let U-Nique Accounting Help You Get It Right
The 2025 tip deduction is great news for restaurants, but only if your reporting is accurate. At U-Nique Accounting, we help restaurants, bars, and breweries align their POS and payroll systems, track labor costs accurately, and claim every credit available to them.
We use Xero to capture daily POS data, categorize tips and auto-gratuities correctly, and generate reports that show your true labor costs, food costs, and beverage margins. With the right setup, you’ll stay compliant, protect your team, and keep more of what you earn.
Schedule a free discovery call today to clean up your reporting and make sure you’re getting the full benefit of the new “No Tax on Tips” rule.
By MATT CIANCIARULO
