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.

Why Is The IRS Looking At Restaurant Tips (Again)?

I recently visited one of our clients. He owns a restaurant/bar. That is a tough business under the best of circumstances.  It is a business where almost all your profit comes from paying attention to the nickels and dimes.

Is there anything new out there, he asked?

We talked about the IRS’ recent interest in employee tips and gratuities. What is the difference?

• A tip is an amount determined by the patron

• A service charge is an amount agreed upon by the restaurant and patron

The IRS has long defined a tip as:

1. Paid free from compulsion
2. Determinable by the customer
3. Not dictated by the restaurant/employer
4. The recipient of which is identified by the customer

You may know that restaurant employees are paid a lower minimum wage, as a substantial part of their income is expected to come from tips. The employees are supposed to report their tips to the restaurant, which in turn withholds the employee’s share of the taxes. The restaurant also pays employer FICA on the base wages and tips.

The IRS has long believed that there exists substantial noncompliance with tip reporting by restaurant employees, and it has rolled out a number of “programs” over the years with the intent of increasing compliance. I have been through several of these, and my conclusion is that the IRS just wants money, even if it takes a work of fiction to get there. For example, if the IRS feels that the cash tip rate is too low, they will simply propose a higher rate, and call upon the restaurant (which then means me) to prove otherwise. Failure to do so means the restaurant is writing a tidy check for those actual taxes on proposed tips.

It is unfortunately too common that a server will be under-tipped if he/she is serving a large party. As a defense mechanism, many restaurants have imposed a service charge policy (also known as an auto gratuity or “auto-grat”) on that table or tables. The policy has worked fine for years.

But not for the IRS. They have recently clarified that they don’t believe auto-grats count as a tips, as the customer does not have the option of changing the amount or directing who is to receive it. I have to admit, the IRS has a point. However, are they making things worse by pressing the point? Let’s go through a few issues:

• The auto-grat will be on the server’s paycheck, rather than cashed out at the end of the shift. This is not a big deal in the scheme of things – except perhaps to the server.

• Restaurants are allowed to claim a tax credit for employer FICA paid on tips in excess of the amount necessary to get a server to minimum wage.

a.     Reduce the amount considered to be tips and you reduce the credit available to the restaurant.

b.     Meaning more tax to the restaurant.

• An auto-grat is considered revenue to the restaurant. Tips are not. States with a gross revenue tax – such as Ohio with its CAT – will now tax those auto-grats.

a.     Meaning more tax to the restaurant.

• Following on the same vein as (3), the customer will pay more sales tax, as the auto-grat is included in sales.

a.     Meaning more tax to the customer.

• How does one (I don’t know: say my accounting firm) figure out what rate of pay to use if the employee works overtime?

a.     Remember, service charges are resetting the base rate of pay.

b.     What if they server works tips and auto-grat tables over the course of one shift? Do they have one rate of pay or two? How would you even calculate this?

• Let’s throw a little SALT (State And Local Tax) into the mix: some states do not follow the federal definitions. For example, New York will consider auto-grats to be considered tips if they are separately stated on the receipt or invoice. New Jersey and Connecticut follow this line also.

a.     The good thing is that auto-grats will not be subject to New York sales tax.

b.     The bad thing is the accounting required to figure this out.

How long do you think it will be before the attorneys eviscerate some restaurant chain for violations of FLSA and overtime regulations? Remember, a service charge can change a server’s base pay, something a tip cannot do. On the other hand, the odds of overtime under the current economy are pretty low.

What about discrimination? How long before someone sues for being scheduled insufficient/excessive service -charge/non-service-charge shifts?

You know what I would do? I would do away with service charges altogether. I am not bringing that tiger to the party. Tips only at my restaurant.

Is it good for the servers? Since when does any of this care whether it is good for the employee?

It is about one thing: more money to the IRS. There may have been a time when I would have been sympathetic to the government’s position, but in this day of credit and debit cards, I am cynical about how much “unreported” income there is left to squeeze out of this turnip. I am also concerned that some restaurants may impose a service charge and then keep a portion of it for themselves rather than pass it along in full to the servers and others.  I am unhumored by the IRS, but I would be beyond unhumored by a restaurant that did that to its employees.