Tax Legislative and Regulatory Updates

What Employers Need to Know About Section 224 and the Qualified Tips Deduction

A quick shout out to my small/midsize clients in occupations where tips are par for the course, many of whom have been paying particular attention to the newly enacted Section 224 regarding "qualified tips" and any new guidance. Well, Treasury and the IRS recently issued proposed regulations, which hopefully will help them navigate the compliance and reporting obligations of this new tax benefit for their employees.

Section 224 introduces a new temporary tax deduction for employees who receive qualified tips in certain occupations. This change, effective for tax years 2025 through 2028, is designed to benefit workers in industries where tipping is customary. However, it also brings new compliance and payroll challenges for employers—especially small and midsize businesses in the hospitality, personal services, and related sectors. Here’s what you need to know to help your employees maximize this benefit and keep your business compliant.

Who’s Affected?

If your business employs workers in jobs that customarily and regularly receive tips—think restaurants, bars, salons, hotels, transportation, and similar service industries—Section 224 is directly relevant to you. The IRS has published a detailed list of qualifying occupations, each with a Treasury Tipped Occupation Code (TTOC). Only tips received in these listed occupations are eligible for the deduction.

What Counts as a Qualified Tip?

• Voluntary Tips Only: Only tips that are voluntarily paid by customers qualify. Mandatory service charges, automatic gratuities, or any payment the customer cannot freely adjust do not count.
• Cash and Equivalents: Qualified tips include cash, checks, credit/debit card payments, gift cards, and tokens that can be readily exchanged for cash. Non-cash items (like event tickets or meals) are excluded.
• Tip Pooling: Tips received through tip-sharing or pooling arrangements are included, as long as they meet the other requirements.
• Reporting is Key: For employees to claim the deduction, tips must be properly reported on Forms W-2, 1099-NEC, 1099-K, 1099-MISC, or on Form 4137 (for unreported tips).

Employer Compliance and Payroll Implications

1. Accurate Tip Tracking and Reporting
o Your payroll systems must be able to separately track and report qualified tips. Only tips that are properly reported on the required forms will be eligible for the deduction.
o For 2025, the IRS is providing some transition relief, but starting in 2026, new reporting requirements will apply—including new boxes on Form W-2 for tip amounts and occupation codes. Plan now to update your payroll and point-of-sale systems.

2. Employee Education
o Employees need to understand what counts as a qualified tip and the importance of accurate reporting. Consider providing training or informational materials to help them maximize their deduction.

3. Tip Pooling Documentation
o If your business uses tip-sharing arrangements, keep clear records of how tips are distributed. This will help substantiate the amounts reported and ensure compliance.

4. No Change to Payroll Tax Obligations
o Section 224 does not affect your obligation to withhold and pay Social Security and Medicare (FICA) taxes on tip income. All reported tips remain subject to payroll taxes.

5. Recordkeeping and Audit Readiness
o Maintain thorough documentation to support the nature and amount of tips reported. This includes evidence that tips were voluntary and not mandatory service charges.

6. Review Job Classifications
o Double-check that your employees’ job titles and duties align with the IRS’s list of qualifying occupations. Misclassification could make employees ineligible for the deduction.

7. Anti-Abuse Provisions
o The IRS is watching for attempts to reclassify wages or bonuses as tips. Do not attempt to reclassify other compensation as tips to take advantage of the deduction.

Potential Compliance Burdens

• System Upgrades: You may need to invest in payroll and point-of-sale system upgrades to meet the new tracking and reporting requirements.
• Increased Recordkeeping: Expect a greater need for detailed records to substantiate tip income and its voluntary nature.
• Ongoing Monitoring: Stay alert for further IRS guidance and updates to reporting requirements as the regulations are finalized.

Key Takeaways for Employers

• Start preparing now by reviewing your payroll systems and internal processes for tracking and reporting tips.
• Educate your employees about the new deduction and the importance of accurate tip reporting.
• Monitor IRS updates and be ready to implement new reporting requirements for 2026 and beyond.
• Maintain robust records and avoid any attempts to reclassify compensation as tips.

By taking these steps, you can help your employees take full advantage of the Section 224 deduction while keeping your business compliant and audit-ready. This is a significant, but temporary, opportunity for workers in tipped occupations—make sure your business is ready to support them.

Stay tuned to TechTaxTalk for more updates on legislative and regulatory changes affecting your business and your workforce.