The classification of tips as taxable income in the United States didn’t originate as a new law in the 1940s but evolved through a combination of existing tax statutes, administrative rulings, and judicial decisions that solidified their status over time. The 1940s marked a period of clarification and enforcement rather than the initial establishment of the rule. Let’s unpack how this developed, who drove it, and when it hit the courts.
Historical Context and Legal Foundation
The groundwork for taxing tips as income traces back to the Revenue Act of 1913, following the ratification of the Sixteenth Amendment, which gave Congress broad authority to tax “incomes, from whatever source derived.” Section II of the 1913 Act defined taxable income expansively, encompassing “gains, profits, and income derived from salaries, wages, or compensation for personal service.” Tips, as payments received for services, arguably fell under this umbrella from the start, though they weren’t explicitly singled out early on.
By the 1930s and 1940s, the U.S. tax system expanded significantly due to economic pressures—first the Great Depression, then World War II. The Revenue Act of 1939 codified the Internal Revenue Code (IRC), and Section 22 (now Section 61) reiterated the broad definition of gross income. The IRS, tasked with interpreting and enforcing this, began focusing on unreported income sources like tips as revenue needs grew. The Revenue Act of 1942, dubbed the “Victory Tax,” dramatically widened the tax base by lowering income thresholds and introducing payroll withholding—shifting tax collection from annual self-reporting to employer-managed deductions. This shift spotlighted tips, especially in service industries, as a form of compensation that wasn’t being systematically taxed.
Initiating Party: The IRS
The Internal Revenue Service (or its predecessor, the Bureau of Internal Revenue) was the primary driver in treating tips as taxable income. While no single person is credited with this decision, it would have likely involved Treasury Department attorneys, IRS policymakers, and possibly officials in the Office of the Chief Counsel for the IRS. The Commissioner of Internal Revenue at the time (1943) was Guy T. Helvering, though it’s unclear if he played a direct role in this specific ruling.
No single law in the 1940s explicitly declared “tips are income”—rather, the IRS interpreted existing statutes to include them. In 1940, the IRS issued Treasury Decision 4962 (T.D. 4962), amending regulations under the Social Security Act to clarify that tips counted as “wages” for Social Security tax purposes if they were under the employer’s control or part of a mandatory service charge. This set a precedent for income tax treatment, as Social Security and income tax definitions often aligned. The IRS argued that tips were compensation for services, not gifts, because they were tied to the work performed—a stance rooted in the “detached and disinterested generosity” test from Commissioner v. Duberstein (1960), though that case came later.
The push intensified in the 1940s as wartime revenue demands exposed underreporting. Service workers—waiters, bellhops, taxi drivers—often pocketed tips in cash, bypassing tax records. The IRS, needing to close this gap, began issuing rulings and guidance. For example, a 1942 IRS ruling (I.T. 3529) stated that tips received by employees were taxable as “additional compensation,” formalizing their position. The agency, not Congress or a specific lawmaker, initiated this enforcement, leveraging its regulatory authority under the IRC.
Judicial Involvement
The issue didn’t hit the courts in a landmark way until after the 1940s, as early challenges were sparse and the IRS’s position was largely unchallenged initially. However, the legal framework was tested later, confirming the 1940s IRS stance:
Roberts v. Commissioner (1948): This Tax Court case, decided on December 30, 1948, is one of the earliest documented challenges to tip taxation. A waiter argued that tips were gifts, not income, citing their voluntary nature. The court rejected this, ruling that tips were “compensation for services rendered” and thus taxable under Section 22 of the 1939 IRC. While not a Supreme Court case, it set a precedent in the Tax Court, aligning with IRS policy established earlier in the decade.
Post-1940s Clarity: The Supreme Court didn’t directly address tips until later cases like United States v. Fior D’Italia (2002), which upheld IRS authority to estimate unreported tips. But the 1940s IRS position held firm, with courts consistently affirming it when challenged.
Why the 1940s?
The 1940s focus stemmed from practical necessity. The Current Tax Payment Act of 1943 mandated employer withholding, but tips—paid directly by customers—fell outside this system. The IRS responded by requiring employees to self-report tips, a rule cemented in the 1940s through administrative action rather than new legislation. The Bureau of Internal Revenue, reorganized as the IRS in 1953, had been building this interpretation since at least the 1930s, but wartime urgency and the 1942-1943 tax reforms made enforcement a priority.
Who Pushed It?
No single “initiating party” like a senator or plaintiff sparked this in the 1940s—Congress provided the broad taxing power, but the IRS took the lead in applying it to tips. Employers and unions occasionally resisted (e.g., the hotel industry grumbled about tracking tips), but the IRS’s regulatory muscle, backed by Treasury Department support, drove the policy. Workers themselves rarely challenged it formally until cases like Roberts emerged.
Let’s Make America Great Again … can the tax on tips
Tips became taxable income through the IRS’s interpretation of the IRC’s expansive income definition, a policy solidified in the 1940s amid wartime revenue demands. Treasury Decision 4962 (1940) and I.T. 3529 (1942) laid the administrative groundwork, with Roberts v. Commissioner (1948) marking an early judicial affirmation. The IRS, not Congress or the courts, drove this shift, leveraging existing law to capture unreported cash. Today, the debate has shifted—proposals to eliminate tip taxes, like those floated in the 2024 campaign by figures such as Donald Trump, reflect growing recognition that tips, often small and discretionary, burden low-wage workers disproportionately. The 1940s made tips taxable; 2025 could unmake that precedent.
Logical Appeal
Taxing tips hits workers already scraping by—servers and drivers earning $2.13/hour under FLSA tip credits shouldn’t lose more to the IRS. Unlike wages, tips are voluntary, unpredictable, and tied to customer’s whim, not a contract. Exempting them boosts take-home pay without bloating bureaucracy, a simple fix for a relic of 1940s revenue grabs.