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Income from tips has been taxed for more than a century – at least in law, if not fully in practice. Despite decades-long grumblings from tipped workers, the possibility of exempting tips from the income tax did not gain political traction until June 2024, when then-presidential candidate Donald Trump, reportedly inspired by a server he met in Las Vegas, Nevada, a state with a high percentage of tipped workers, vowed that if elected he would urge Congress to exempt tips from federal income tax.  

That campaign promise may soon become law. The No Tax on Tips Act, which would exclude tips as taxable income, is making its way through Congress and will likely be included in this year’s tax legislation — despite the possible revenue loss of tens of billions of dollars.

Why now? Lawrence Zelenak, an expert on taxation and tax policy, says the answer is partly the political moment, but more about the dominance of credit cards over cash as a method of payment in restaurants and other businesses with tipped workers.  

When cash was the dominant method of payment, workers could underreport tip income on their tax returns. Now, most tips are added to credit and debit card payments, creating a record of income that employers report to the Internal Revenue Service (IRS).

“In the last decade or so, paying for meals and tips by credit card has become so overwhelmingly the norm, and cash tips are in such a minority now,” said Zelenak, the Pamela B. Gann Distinguished Professor of Law at Duke Law School.

“For the first time, the vast majority of tips are actually being taxed and therefore getting an official exemption becomes a bigger deal.” 

How tip tax works

Tips — whether given in currency, checks, or credit or debit card charges or in non-cash items such as tickets or passes — are subject to federal income tax and must be reported on returns, according to IRS guidelines that define tips as “discretionary (optional or extra) payments determined by a customer that employees receive from customers.” It's been that way since a 1919 Treasury regulation declared that tips were a form of taxable compensation for services.

In his article Why Nip a Tip Tax Now? Zelenak writes that in the pre-credit card days, the tax compliance rate for tip income was extremely low, with the IRS collecting taxes on only about 15% of total tip income. 

“The vast majority of tips were in cash, and there was really no way for the IRS to find out that someone had received that income unless they voluntarily reported it, and most people did not,” Zelenak said. “Bob Dole, then chair of the Senate Finance Committee, was deeply bothered by this.” 

Dole backed a provision in the Tax Equity and Fiscal Responsibility Act of 1982 that provided a mechanism for enforcing tip taxation – to some extent. Employers had to calculate and report to the IRS a sum of tips received that was equal to 8% of their food and beverage sales.

“If people didn't voluntarily report at least that much, then the employers would have to make it up,” Zelenak said. “And if you estimate that the actual tip rate back then was probably someplace around 15%, what that was doing, in effect, was forcing taxation of about half of all tips.”

That 50% compromise has held ever since. But the 1980s were also the beginning of a rise in credit card usage — fueled by the growing availability of electronic point-of-sale processing and a marketing boom that would make bank-issued cards the preferred method of payment for everything from consumer goods to restaurant meals.

In 2023, consumers used cash in only 16% of transactions — about half as much as in 2016 — while credit and debit cards were used for 62% of payments, according to The Federal Reserve Financial Services’ 2024 Diary of Consumer Payment Choice.

But while the convenience of cards has been appealing to consumers, it's also added to tipped workers’ tax burden, said Zelenak. Adding a tip to a credit card bill creates a record of reportable income for the IRS, making it more difficult to hide income, and Zelenak estimates the tax compliance rate for tip income is now around 80% to 90%.

Seizing a political moment

A tip exemption could cost the U.S. $150 billion to $250 billion in lost revenue over 10 years, according to estimates by the nonpartisan Committee for a Responsible Federal Budget. And the exemption must be carefully designed to discourage fraud and abuse, and to avoid hurting tipped workers by reducing their refundable tax credits and Social Security benefits, Zelenak noted.

But he predicts it will pass. Lawmakers must tackle tax legislation before the 2017 Tax Cuts and Jobs Act expires at the end of the year, and the most viable bills in the House and Senate, which would allow workers to deduct up to $25,000 of cash tips as taxable income, have bipartisan support.

“What really pushed the statutory tip exemption over the edge as a topic of serious political discussion was the growth of credit cards, the improvisational nature of Trump’s policy proposals, and the fact that Nevada, with its high percentage of tipped workers, was a swing state in the last election,” Zelenak said.

“You had this rare agreement on a policy issue between the two candidates because somebody happened to mention the issue to Trump, he proposed a tip exemption, and Kamala Harris followed suit to avoid losing Nevada over such a relatively minor issue."