The “no tax on tips” promise has generated enormous interest among California’s 1.5 million restaurant and hospitality workers. With the One Big Beautiful Bill Act (OBBBA) signed into law on July 4, 2025, certain tip income now receives preferential tax treatment for the first time in modern tax history. But the reality is more nuanced than the headlines suggest—and understanding exactly what changed, who qualifies, and how to properly report your income is essential to avoid problems with the IRS.
At the Law Office of Pietro Canestrelli, we’ve received hundreds of questions from restaurant workers, bartenders, hotel staff, and other tipped employees about how the new law affects them. As a former IRS agent and California Board Certified Tax Specialist, Pietro Canestrelli is uniquely positioned to explain both the opportunities and the compliance requirements of this significant tax change. This guide provides everything California tipped workers need to know.
What the “No Tax on Tips” Provision Actually Does
The OBBBA created a new tax treatment for qualifying tip income, but it’s not an unlimited exemption from all taxes. Here’s what actually changed:
Federal Income Tax Treatment
Qualifying tip income may be excluded from federal taxable income, meaning you won’t pay federal income tax on tips that meet the law’s requirements. However, several important limitations apply:
- Income cap: The exclusion phases out for higher earners—workers with total wages above certain thresholds see reduced benefits
- Qualifying industries: The exemption targets traditionally tipped occupations (food service, hospitality, personal services)
- Cash tips only: The treatment applies primarily to cash tips reported by employees
- Reporting requirements remain: You must still report all tip income to your employer and the IRS—the exemption doesn’t eliminate reporting obligations
What’s NOT Exempt
Understanding what the law doesn’t change is equally important:
- Social Security and Medicare taxes: FICA taxes still apply to tip income—the exemption is for income tax only
- California state income tax: California has not enacted a corresponding state-level exemption, meaning tips remain fully taxable for California state income tax purposes
- Employer obligations: Employers must still withhold and pay their share of FICA taxes on reported tips
For a complete overview of the OBBBA’s provisions, see our analysis of who benefits from the Big Beautiful Tax Bill.
Who Qualifies for the Tip Income Exemption?
Not all tipped workers automatically qualify. The law targets specific industries and imposes income limitations:
Qualifying Occupations
Workers in traditionally tipped service industries are the primary beneficiaries:
- Restaurant servers and waitstaff
- Bartenders
- Hotel housekeeping and bellhops
- Hairdressers and barbers
- Nail technicians and spa workers
- Casino dealers
- Food delivery drivers
- Valets and parking attendants
Income Limitations
The exemption is designed to help working-class tipped employees, not high earners. Phase-out thresholds apply based on total compensation. Workers earning significantly above the median for their occupation may see reduced or eliminated benefits.
California Restaurant Workers: Special Considerations
California’s unique wage laws create additional complexity. Unlike states with a tip credit, California requires employers to pay the full minimum wage ($16.50/hour in 2026 for most employers) before tips. This means California tipped workers often have higher base wages than their counterparts in other states—which can push some workers closer to income phase-out thresholds.
California State Tax: Tips Remain Fully Taxable
Here’s the critical point many California workers miss: the federal exemption does not apply to California state income tax. Tips remain fully taxable income for purposes of the California Franchise Tax Board.
This creates a situation where:
- You may owe $0 federal income tax on qualifying tip income
- You still owe California state income tax on that same tip income
- You still owe Social Security and Medicare taxes on tips
California’s top marginal tax rate of 13.3% means state taxes remain a significant consideration for tipped workers, even with the federal exemption. Understanding California tax compliance requirements is essential.
Reporting Requirements Haven’t Changed
A common misconception is that “no tax on tips” means tips don’t need to be reported. This is absolutely false and could lead to serious problems with both the IRS and California FTB.
Employee Reporting Obligations
You must still:
- Report tips to your employer: If you receive $20 or more in tips in any month, you must report them to your employer by the 10th of the following month (Form 4070 or equivalent)
- Keep daily records: The IRS recommends keeping a daily tip log documenting date, cash tips, charged tips, and tips paid out to others
- Report on your tax return: All tip income must be reported on your Form 1040, even if it qualifies for the exemption
Employer Withholding
When you report tips to your employer, they’re required to:
- Withhold Social Security and Medicare taxes
- Withhold federal and state income tax (though the federal amount may be reduced or zero under the new exemption)
- Report tips on your W-2
If you don’t report tips to your employer, you’re still responsible for paying Social Security and Medicare taxes directly when you file your return (Form 4137).
Common Mistakes That Can Trigger IRS Problems
The IRS has sophisticated methods for estimating unreported tip income. Here are mistakes that can trigger audits and penalties:
Underreporting Tip Income
The IRS knows that servers at certain types of restaurants typically receive tips averaging 15-20% of sales. If your reported tips are significantly below this threshold, you may face an audit. The agency also receives data from credit card companies showing charged tips—if cash tips seem disproportionately low compared to charged tips, that’s a red flag.
Inconsistent Reporting
If you report $30,000 in tips to your employer but claim different amounts on your tax return, you’ll trigger an immediate mismatch notice from the IRS.
Ignoring State Tax Obligations
Some workers, excited about the federal exemption, may forget that California taxes remain due. The FTB shares data with the IRS and can identify unreported tip income.
If you’re concerned about past reporting, our practice areas page explains how we help taxpayers resolve compliance issues.
The Impact of IRS Tracking on Tip Income
The IRS has invested heavily in detecting unreported tip income. Modern enforcement tools include:
- Credit card data: Electronic payments leave a trail—the IRS receives information about charged tips
- Employer audits: When the IRS audits a restaurant, they often examine whether tip reporting matches expected patterns
- Statistical analysis: The IRS uses industry benchmarks to identify outliers
- Whistleblower tips: Disgruntled former employees sometimes report cash tip schemes to the IRS
For more on IRS tracking methods, see our article on how the IRS tracks various income sources.
Planning Strategies for California Tipped Workers
With proper planning, you can maximize the benefits of the new law while remaining compliant:
Accurate Record-Keeping
Keep a contemporaneous daily tip log. This protects you if the IRS questions your reported amounts and ensures you don’t inadvertently underreport (losing Social Security credits) or overreport.
Understand Your Withholding
With the federal exemption reducing your income tax liability, your withholding may now be excessive. Consider adjusting your W-4 to avoid overwithholding—but be careful not to under-withhold for California state taxes.
Plan for California Taxes
Since tips remain taxable in California, ensure you’re setting aside money for state taxes. Workers who previously relied on federal withholding to cover state liability may face a surprise state tax bill.
Consider Retirement Contributions
Even with the federal exemption, contributing to a traditional IRA reduces your California taxable income. This can help offset the state tax burden on tips.
For comprehensive tax planning guidance, explore our tax education resources.
What Employers Need to Know
Restaurant and hospitality business owners in California face their own compliance requirements under the new law:
Tip Reporting Obligations
Employers must continue collecting tip reports from employees and reporting tip income to the IRS. The exemption doesn’t eliminate employer reporting requirements.
FICA Responsibilities
Employers still owe their share of Social Security and Medicare taxes on reported tips. This obligation is unchanged by the new law.
Withholding Adjustments
Payroll systems may need updating to properly calculate reduced federal income tax withholding on qualifying tip income while maintaining full state withholding.
For business owners, our article on OBBBA implications for California businesses provides additional guidance.
Frequently Asked Questions
Do I still need to report my tips if they’re not taxed?
Yes. Reporting requirements are completely unchanged. You must report tips to your employer and on your tax return. The exemption only affects whether federal income tax is owed—not whether the income must be reported.
What about tips on credit cards?
Tips paid via credit card are treated the same as cash tips for purposes of the exemption. However, credit card tips create automatic documentation, making accurate reporting even more important.
Can I claim the exemption on tips from years before 2025?
No. The exemption is effective for tax years beginning January 1, 2025, and forward. You cannot amend prior year returns to claim an exemption that didn’t exist.
What if my employer doesn’t report all my tips?
You’re still responsible for reporting all tip income, regardless of what your employer reports. Underreporting to avoid taxes is illegal and can result in penalties, interest, and potential criminal charges.
Does this affect my Social Security benefits?
Since Social Security taxes still apply to tip income, your eventual benefits are calculated based on total reported earnings including tips. The income tax exemption doesn’t affect your Social Security benefit calculation.
What to Do If You Have Past Tip Reporting Issues
If you’ve underreported tips in previous years, now is the time to address the issue—before the IRS contacts you. Options include:
- Filing amended returns: Correcting past underreporting voluntarily typically results in lower penalties than waiting for IRS discovery
- Voluntary disclosure: For significant underreporting, a formal voluntary disclosure may be appropriate
- Going forward compliance: At minimum, ensure accurate reporting going forward
Our team has helped many service industry workers resolve past compliance issues. Learn about the consequences of non-compliance and how we can help.
Get Expert Guidance on Tip Income Taxation
The new “no tax on tips” provision creates genuine benefits for California’s restaurant and hospitality workers—but only for those who understand the rules and comply with ongoing reporting requirements. Misunderstanding the law can lead to IRS audits, penalties, and unexpected California state tax bills.
At the Law Office of Pietro Canestrelli, we help California workers navigate complex tax situations. Whether you need help understanding how the new exemption applies to your situation, resolving past tip reporting issues, or planning for your tax obligations, our team provides expert guidance backed by former IRS experience.
Have questions about tip income taxation? Contact our team for a consultation. We’ll help you understand your obligations and ensure you’re taking full advantage of available tax benefits while staying compliant.
