Will I Qualify For The Tips Deduction?

 

Can I take advantage of the new tips deduction?

I will be slowing down in 2026: fewer hours, fewer clients, unlikely to accept new clients. It was inevitable, but the events of the last year-plus have accelerated my decision. I was witness to friends and the consequences from their sale of a firm. I do not care to see that again.

Can I do anything in 2026 to catch a tax break?

We are talking about the “No Tax On Tips” provision of the One Big Beautiful Bill signed by the President on July 4, 2025. The break will last four years – beginning in 2025 – and allow a tipped worker to exclude up to $25,000 of “qualified” tips from income taxes.

COMMENT” Yes, the break is retroactive to January 1, 2025 even though the OBBB was not signed until July 4.

COMMENT: The $25 grand is per return. If you file single, the limit is $25 grand. If you file jointly, the limit is again $25 grand. Another important point is that we are talking about federal income taxes only. Those tips are still going to be subject to social security taxes, just like before.

There is an income limit, of course: $150 grand for singles and $300 grand for marrieds.

The break is available whether you are a tipped employee or tipped self-employed. The reporting to you, however, will be different.

If you are an employee, you will receive a 2025 Form W-2 from your employer.

I want you to notice Box 7: Social Security Tips.

The tips deduction uses the term “qualified” tips.

Mind you, it is possible that Box 7 is also the amount for qualified tips, but it does not have to be. The tax Code does this sleight-of-hand repetitively by sliding the word “qualified” before otherwise innocuous nouns. How can a tip be “nonqualified?” Easy: it is nonvoluntary. How does that happen? Again - easy. Say that you have a party of eight or more and the restaurant applies an automatic gratuity of 18%. That fact that the gratuity/tip is now automatically included means that it is nonvoluntary, which means it is not “qualified,” which means it does not qualify for the tips deduction.

So ... how is one to know how much of box 7 is qualified?

Fortunately – and given that the law was passed halfway into the year – the IRS realized that employers and payroll companies could not make these changes retroactively. In Notice 2025-62, the IRS stated that - for 2025 only - an employee can assume that Box 7 is the same amount as qualified tips. Employers can also get this information to employees via other means, such as an online portal.

A new W-2 will be in place for 2026.

What about tipped self-employeds?

Now we are circling back to my situation and the tips deduction.

Scratch that Form W-2, as I will not be an employee. I may get some flavor of Form 1099, though.

Form 1099-K         used for credit and debit cards

Form 1099-NEC    used for independent contractor

Form 1099-MISC  used for other reportable payments

I took a look: nope, not seeing any 2025 reporting for tips. I see something on Form 1099-MISC Box 10 for payments to an attorney, but I am not an attorney. The IRS has said, however, that they are revising the 2026 forms to include tips information. That's OK, I will adjust my 2026 invoices as necessary - if I can otherwise qualify for the deduction.

I gotta ask: how will the IRS know if I am self-employed and have 2025 income representing qualified tips?

I see the following IRS guidance: “you can rely on your own tip records.”

Not the hardest tax planning I have seen.

The IRS buttressed this with proposed Regulations on September 22, 2025.

I see four requirements in the Regulations for a qualified tip:

·      Is paid voluntarily

·      Is not received in a specified trade or business

·      Satisfies other requirements established by the Secretary

·      Received in an occupation that customarily and regularly received tips on or before December 31, 2024

Let’s see:

·      I can meet this: you can pay me voluntarily or involuntarily, but you will pay me.

·      This is a problem. I am not going to labor you with the provenance and metaphysics of “specified trades or businesses,” other than to say that common examples include physicians, attorneys, and accountants.

o   But there is transitional relief until January 1 “of the first calendar year following the issuance of final regulations ….”

§  I may still be in the running.

·      I will worry about other requirements when they happen.

·      We hit a hard stop with “customarily and regularly received tips.”

o   The IRS published a list of qualifying occupations.

o   I see the expected: bartenders, wait staff, hair stylists, and so forth.

o   I see a few unexpected: home landscapers, electricians, and plumbers.

o   I see nothing for accountants and tax preparers.

o   I do see something for “#209 Digital Content Creators.”

§  I suppose I could put these blogs on YouTube and be a “content creator.”

I am not seeing a (reasonable) way to meet that fourth requirement and get my 2026 fees to qualify for the tips deduction, unfortunately. I suppose an occasional client might mark my fee as a “tip” – thereby hoping to help me out – but I am not seeing a way to sidestep (at least legitimately) the “customarily and regularly” hurdle.

I won’t, but you know somebody will.

The tax literature is littered with cases like these.

Abusing A Tax-Exempt

I am looking at a tax-exempt case that went off the rails.

There are rules in the tax-exempt area to encourage one to keep their nose clean. The rules can be different depending on whether the entity is a private foundation or not. The reason is that a foundation is generally considered more susceptible to influence than a “classic” tax-exempt, such as a 501(c)(3), as a foundation generally has a smaller pool of donors.

A doctor (Dr O) organized a 501(c)(3) called American Medical Missionary Care, Inc (AMMC) in 1998. In 2000 it applied for and received tax-exempt status from the IRS. Its exempt purpose was to operate a clinic in Michigan providing medical examination and treatment for individuals unable to afford such services.

Sounds like a great cause to me.

Dr O served as president. His spouse (Mrs O) served on the board of directors as well as secretary and treasurer over the years.

In 2013 AMMC filed its Form 990 reporting compensation of $26,000 paid Dr O and $21,000 paid Mrs O.

AMMC however issued W-2s of $26,000 apiece.

There is a mistake here, but it is not necessarily a big deal. They should tighten down the numbers going forward, though.

On its 2014 Form 990 AMMC reported no compensation to Dr or Mrs O.

Seems odd. Compensation does not tend to turn off and on like a spigot.

Meanwhile, Dr O had gotten in trouble with the Michigan Board of Medicine in 2014. He was required to pay a significant amount of money and also relinquished his medical license. Dr O eventually returned to Nigeria in 2017, leaving his wife in the United States.

The IRS selected the nonprofit for examination.

The revenue agent dug around the AMMC’s various bank accounts for 2014 and found biweekly checks to Mrs O of $1,000 each. There were also certified checks ranging from $6,000 to $10,000. In all, Dr and Mrs O had received cash, checks and money orders from AMMC totaling approximately $130 thousand.

The 990 showed the $130 grand as a loan receivable from Dr O.

Oh please.

Dr O got into trouble and needed cash. He turned to AMMC because that is where the money was. A loan implies an ability to repay and intent to collect, all within the normal course and conduct of business. I seriously doubt that is what we had here.

Dr O and Mrs O had outsized influence over the (c)(3). Who was going to tell them no, much less point out that making loans to officers and board members is minefield territory in the tax Code?

The IRS revenue agent felt the same way and assessed a tier-one penalty.

Penalties in the nonprofit area can be a bit different. There can be penalties on an individual or on the entity itself, for example. The more severe penalties revolve around “excess benefit” transactions and “disqualified persons,” which are – as you might suspect – people with substantial authority or influence over the tax-exempt. Dr O organized AMMC years before and served as its president. He was a poster child for a disqualified person.

The IRS assessed a tier-one penalty of $32,500. It also revoked the exempt status of AMMC.

Let’s walk through the tiered penalty.

The IRS assessed a tier-one penalty of $32,500 on the O's. This is 25% of the $130,000 that Dr and Mrs O drew in 2014. The reason I call it a “tier-one” is that there is a possible “tier two.” To avoid a tier-two, one has to return the money to the tax-exempt.

What happens if one fails to return the money?

The penalty goes to 200%.

This is one of the severest penalties in the tax Code, and Congress intended it that way. Years ago, the only recourse the IRS had was to revoke the entity’s exempt status. Congress felt that this response was a sledgehammer, and it instead created a set of “intermediate” penalties, shifting the burden to the person benefiting from the transaction. With that as background, Congress did not consider 200 percent as excessive.

So the O’s now had another penalty of $230,000.

COMMENT: 200 percent of $130,000 is $260,000, not $230,000. The Court made some tweaks which need not concern us here.

You may be wondering why Dr O would care, if he was safely ensconced in Nigeria.

For one, his wife was still in the United States.

And she was on the Board. She had served as secretary and treasurer. She was a disqualified person in her own right. She was also considered to be a disqualified person by being married to a disqualified person. She was not getting out of this snare.

Mrs O was going to get hammered.

She fielded a last stand:

(1) She argued that much of the money was distributed to needy people to help with rent and utilities, after-school programs for the kids and so forth.

Problem was: she had no records to substantiate any of this. She had not drawn checks in a manner commensurate with this storyline, although she testified that she would hold and re-deposit the certified checks back into the (c)(3) if and as needed. The Court was – by this point – quite skeptical of anything she had to say.

(2)  She argued that much of the money represented compensation to either her or both Dr O and her.

This was her best argument, but unfortunately this route was closed to her.

You see, AMMC should have issued W-2s if it intended for the monies to represent compensation. The tax-exempt did not issue W-2s for 2014. It did not even authorize compensation in its minutes. Some things have to be done currently, and this is one of those things.

A W-2 (or 1099) would have saved a penalty equal to twice its face amount. That is, a $26,000 W-2 to Dr O would have saved a penalty of $52,000 ($26,000 times 200%).

It was a worst-case scenario for the O’s.

Then again, they abused AMCC. That money did not belong to the O’s. It belonged to the (c)(3). The exempt purpose of AMMC was to assist the poor with access to medical care, not to enrich its founding family after the loss of a medical license.

Our case this time was Ononuju v Commissioner, T.C. Memo 2021-94.

 

LLC Members and W-2s

There is a tax issue that has dogged advisors for years. 

It has to do with limited liability companies.

What sets it up is tax law from general partnerships.

A general partnership is the Gunsmoke of partnerships. The “general” does not means everybody participates. It does mean that everyone is liable if the partnership gets sued.

Whoa. There is clearly a huge downside here.

Which leads us to limited partnerships. Here only a general partner takes on that liability thing. A limited partner put his/her capital account at risk, but nothing more. Forget about signing on that bank debt.

Let’s present the granddaddy of self-employment tax law:

·        A general partner is considered self-employed and pays self-employment tax on his/her distributable income, irrespective of his/her own involvement in the trade or business.

·        A limited partner is presumed to not be involved in the trade or business of the partnership; therefore, he/she does not pay self-employment (SE)  tax on his/her distributable income.

o   There is an exception for “guaranteed payments, which is akin to a salary. Those are subject to SE tax.

How can we differentiate a general partner from a limited partner?

It is that liability thing. The entity is likely being formed under state “limited partnership” law rather than “general partnership” law. In addition, the partnership agreement will normally include a section specifying in detail that the generals run the show and the limiteds are not to speak until spoken to.

Then came the limited liability companies (LLCs).

These caused tax planners to swoon because they allowed a member to actually participate in the business without forfeiting that liability protection.

COMMENT: BTW the banks are quite aware of this. That is why the bank will likely request the member to also sign personally. Still that is preferable to being a general, where receipt of the partnership interest immediately makes you liable.

Did you catch the use of the word “member?” Equity participants in an LLC are referred to as “members,” not “partners.”

So how are LLCs taxed?

Like a partnership. 

COMMENT: I know. All we did was take that car around the block.

Let’s return to that self-employment issue: is a “member” subject to self-employment tax because he/she participates (like a general) or not subject because he/she has limited liability (like a limited)?

It would help if the IRS had published guidance in this area since the days of the Rockford Files. Many advisors, including me, reason that once the LLC is income-taxable as a partnership then it is also self-employment taxable as a partnership. That is what “like a” means. If you work there, it is self-employment income to you.

But I do not have to go far to find another accountant who disagrees with me.

What to do?

Some advisors allow their LLC member-clients to draw W-2s.

Some do not.

There is a problem, however: a member is not considered an employee. And one has to be an employee to receive a W-2.

The fallback reasoning for a long time has been that a member “is like” an employee, in the same sense that I am “like” LeBron James.

It is not technically-vigorous reasoning, and I could not guard LeBron with a squad of Marines by my side.

Then the IRS said that it would respect a single-member LLC as the employer of record, rather than going up the ownership chain to whoever the sole owner is. The IRS would henceforth treat the single-member as a corporate employer for employment taxes, although the single-member would continue to be disregarded for income tax purposes (it is confusing, I know).  The IRS included exceptions, examples and what-nots, but they did not include one that addressed LLC members directly.

The members-want-W-2s school used this notice to further argue their position. You have the LLC set-up a single-member subsidiary LLC and have the subsidiary – now considered a corporate employer – issue W-2s to the members. Voila!    

Let’s be clear why people care about this issue: estimated taxes. People do not like paying estimated taxes. It requires a chunk of money every three months. Members pay estimated taxes. Members would prefer withholding. Withholding comes out of every check, which is less painful, and don’t even talk about that three-month thing.    

The IRS has backed-off the member/W-2 issue for a long time.

However the IRS recently issued guidance that the above “parent-subsidiary” structure will not work, and taxpayers have until August 1 to comply. The IRS did this by firing its big guns: it issued Regulations. There are enhanced disclosure requirements when one takes a position contrary to Regulations, and very few practitioners care to do that. It is considered a “call me to book the audit” disclosure.

The IRS has given these advisors little more than two whole months to rope-in their errant LLC clients. 

Although the window is tight, I agree with the IRS on this one, except for that two-month thing. They feel they have floated the change long enough to alert practitioners. I would have made it effective January 1, 2017, if only for administrative ease. 

Still this is an area that needs improvement. While the IRS is concerned that member W-2s may lead to members inappropriately participating in benefit plans, there is also mounting demand for member withholding. 

Perhaps the answer is to allow withholding but to use something other than a W-2. One could design yet another 1099, and the member would attach it to his/her tax return to document the withholding. Any additional paperwork is a bother at the LLC level, but it would just join the list of bothersome things. The members wanting withholding would have to employ their powers of persuasion.

Sounds like the beginning of a compromise.

How To Lose A Tax Deduction For Wages Paid

This weeks’ tax puzzler involves a mom and her kids.

We again are talking about attorneys. Both mom and dad are attorneys, and mom is self-employed.

Sometimes she brought her children to the office, where they helped her with the following:

·        answering the telephone

·        mail

·        greeting clients

·        photocopying

·        shredding unneeded documents

·        moving files

Mom believed that having her children work would help them understand the value of money and lay the foundations for a lifelong work ethic.

She had three kids, and for 2006, 2007 and 2008 she deducted wages of $5,500, $10,953 and $12,273, respectively.

There are tax advantages to hiring a minor child. For example, if the child is age 17 or younger, there are no social security (that is, FICA) taxes. In addition, there is no federal unemployment tax for a child under age 21, but that savings pales in comparison to the FICA savings.

Then you have other options, such as having the child fund an IRA. All IRAs require income subject to social security tax. It doesn’t matter if one is an employee (FICA tax) or is self-employed (self-employment taxes), but social security is the price of admission.

Her children were all under the age of ten. Can you imagine what those IRAs would be worth 50 years from now?

The IRS disagreed with her deducting payroll, and they wound up in Tax Court.

Your puzzler question is: why?

(1) You: The Court did not believe that the kids really did anything. Maybe she was just trying to deduct their allowances.

Me: The tax law becomes skeptical when related parties are involved, and you cannot get much more related than a mother and her children.  It was heightened in this case as the children were so young. For the most part, though, the Court believed her when she described what the children did.

(2) You: Mom used the money she “paid” the kids for their support – like paying their school tuition, for example.

Me: The tax law disallows a deduction if the money is disguised support, which tax law expects to be provided a dependent child. In this case, the Court saw the children buying books, games and normal kid items; some money also went to Section 529 plans. The Court did not believe that mom was trying to deduct support expenses.

(3) You: She could not provide paperwork to back-up her deductions. What if she paid the kids in cash, for example?

Me: Good job. One reads that the Court wanted to believe her, but she presented no records. She did not provide bank statements showing the kids depositing their paychecks, presumably because the children did not have bank accounts.

She did not provide copies of the Section 529 plans. That was so easy to do that I found the failure odd.

At least she could show the Court a Form W-2.

Mom had not even issued W-2s.

The Court was exasperated.

It allowed her a deduction of $250 per child, as it believed that the kids worked. It could not do more in the absence of any documentation.

And there is the answer to the puzzler.

Too often it is not mind-numbing tax details that trip-up a taxpayer. Sometimes there is just a lapse of common sense.

Like issuing a W-2 if you want the IRS to believe you paid wages to somebody.