Government

A Proposed Law That Would Exclude Tips From Income Taxes Will Create More Problems Than Benefits

The law will have to be drafted with specific and precise language because inaccurate or imprecise wording could include more people than the law intended.

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atl-piggy-bankDuring his election campaign, former president Donald Trump called for eliminating income taxes on tip income for restaurant workers. It was mostly dismissed as an unlikely campaign promise. But when Vice President Kamala Harris also promoted this idea during her presidential campaign, there was speculation such a proposal could one day become law, likely as part of a bigger tax reform bill.

Indeed, a bill called the No Tax On Tips Act, proposed by Sen. Ted Cruz and currently in Congress, would exclude tip income from income and employment taxes. While the bill is unlikely to immediately pass, it provides a glimpse into what can happen in the future.

Excluding tip income would provide more money that can be used for necessities for people in traditionally low-paying jobs. This may also stimulate the economy.

Despite benefiting working-class Americans, the negatives greatly outweigh the positives.

In the past, when cash was the preferred method of payment in restaurants, tips were directly paid to the server rather than to the restaurant. To ensure that the tips were part of the payroll calculations, the IRS has required employees to report their tip income on the Form 4070 which is then given to the employer. The problem was that many restaurant owners did not know about this requirement and simply let the employees keep the tip money and deal with the tax consequences themselves. Nowadays, due to the increased use of debit and credit cards in restaurants, tip income is easier to track and report.

The first problem is that it will make the tax laws more complicated. Thankfully, many years ago, the IRS defined what constitutes a tip in Revenue Ruling 59-252. For a payment to be considered a tip, the payment by the customer must be voluntary with no restrictions and not subject to negotiation or dictated by employer policy. Generally, the customer has the right to determine precisely who shall be the recipient of his generosity.

For example, a lawyer’s contingency fee award will not be considered a tip because the amount is generally negotiated prior engagement.

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States may opt to not follow federal law and tax tips on their own in order to maintain tax revenue and unemployment funds.

This also creates problems with equity. Restaurant tips are paid as a percentage of the total bill. This means that employees of expensive restaurants will have an advantage despite more or less providing the same service. Activists might pressure expensive restaurants to adopt hiring practices that promote diversity, equity, and inclusion at the risk of being review bombed.

While the presidential candidates specifically mentioned tip income for restaurant or food service employees, the tax law will have to specifically state who is subject to tax-free tip income. Otherwise the law will apply to everyone. The law will have to be drafted with specific and precise language because inaccurate or imprecise wording could include more people than the law intended.

On that note, other trade and special interest groups will demand that other professions that customarily receive tip income also be subject to tax-exempt treatment. As Election Day approaches, don’t be surprised if either of the candidates expand the list of people and professions that would qualify for tax-free gratuities.

Finally, exempting tip income from taxes will hurt Social Security. It will reduce contributions to a fund already in danger of being depleted. Also, from the employee’s perspective, this may be their only contribution to retirement. An unfortunate reality is that most people in jobs with tip income are living paycheck to paycheck. If their income is not subject to mandatory contributions done through employer withholdings, they might not have a retirement account because the money will be spent on food, shelter, medicine, student loans, or truffle-sprinkled avocado toast.

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While the idea has good intentions, exempting tips from income tax will further complicate the tax laws, incentivize businesses to convert to a tip-based compensation structure, deprive a subset of people of future social security benefits, and exacerbate tip culture.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at [email protected]. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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