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.

Substantially Disclosing A Gift To The IRS

Take a look at this memorable prose:

         Sec 6501(c) (9) Gift tax on certain gifts not shown on return.

If any gift of property the value of which (or any increase in taxable gifts required under section 2701(d) which) is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b) ), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.

I get it: if you never disclose the gift, the IRS can come after you until the end of time. The reverse is what concerns us today: if you disclose the gift “in a manner adequate,” then the IRS does not have until the end of time.

Gift tax cases can be … idiosyncratic, to be diplomatic. All tax is personal, but gift tax can be Addams Family idiosyncratic.

Ronald Schlapfer (RS) was a Swiss-born businessman. He had ties to both Switzerland and the United States. He owned a life insurance policy issued in 2006.The policy in turn owned all the stock in EMG, a Panamanian company previously owned by RS.

It was 2006 and RS was a nonresident of the U.S. He gifted his interest in EMG to his mother, aunt and uncle.

He obtained U.S. citizenship in 2008.

Got it: he gifted before he became subject to U.S. gift tax.

In 2013 – and after obtaining his citizenship – RS decided to play it safe and submitted an offshore voluntary disclosure filing with the IRS. It included a gift tax return for 2006, which informed the IRS of the gift to his family. The return included the following:

“A protective filing is being submitted. On July 6, 2006, taxpayer made a gift of controlled foreign company stock valued at $6,056,686 per U.S. Treasury Regulation 25.2501-1(B). The taxpayer is not subject to U.S. gift tax as he did not intend to reside permanently in the United States until citizenship was obtained in 2008.”

COMMENT: In this situation, a protective filing means that the taxpayer is unsure if a filing is even required but is submitting one, nonetheless. It is an attempt to backstop penalties and other bad things that could happen from a failure to file.

COMMENT: International practice has become increasingly paranoid for many years now. The IRS seems convinced that every UBER driver has unreported foreign accounts, and one’s failure to follow arbitrary and obscure rules are a per se admission of culpability. In this case, for example, there was technical doubt whether the gift was reportable as the transfer of a life insurance policy or as the transfer of a company owned by that policy. Why was there doubt? Well, the IRS itself created it. Rest assured, whichever way you chose the IRS would fall the other way.

The IRS disagreed that the gift occurred in 2006. There was a hitch in the transfer, and the attorney did not resolve the matter until 2007. RS in turn argued that 2007 was but a scrivener’s error. According to well-trod ground, a scrivener’s error is considered administrative, not substantive, and does not mark the actual date of the underlying transaction.

Sometime in here RS agreed to extend the limitations period.

In 2019 the IRS issued the statutory notice of deficiency (SNOD). That is also called a 90-day letter, and it meant that the next step was Tax Court - if RS wanted to further pursue the matter.

Off to Tax Court they went.

RS’ argument was simple: the statute of limitations had expired.

The IRS argued that the gift was not adequately disclosed.

The IRS argued that disclosure requires the following:

·       Description of the property gifted, and any consideration received by the donor.

·       The identity and relationship between the parties.

·       There is additional disclosure for property is transferred in trust.

·       A detailed explanation of how one arrived at the fair market value of the property gifted.

·       Whether one has taken a position contrary to any Regulations or rulings

The IRS was trying to catch RS in the first requirement above: a description of the property gifted.

Was it an insurance policy, ownership in a company, or something else?

Here is the Court:

While Schlapfer may have failed to describe the gift in the correct way, he provided enough information to identify the underlying property that was transferred.”

RS won his case. The IRS had blown the statute of limitations.

Our case this time was Schlapfer v Commissioner, T.C. Memo 2023-65.

Why Does Arkansas Think You Would Pay Taxes Voluntarily?

“This appeal arises from a dispute of ad valorem taxes.”

Thus begins the Arkansas Supreme Court decision in Outdoor Cap Co v Benton County.

Outdoor Cap Co (Outdoor Cap) makes – as you can guess – caps and other headwear. They are located in Bentonville, where Walmart is headquartered.

Ad valorem taxes are paid on the value of real or personal property. An example is property taxes assessed on business equipment; another example would be the annual property taxes a Kentucky resident pays on his/her car

Outdoor Cap has been paying property taxes since 1976. In 2011 it filed for a refund of its 2008 and 2009 taxes. It wanted a refund of over $247,000.

The reason for the refund? They made a mistake. They paid taxes on their inventory and (some of) that inventory was entitled to a “freeport” exemption.

This is a term we have not discussed before. The easiest way to understand the freeport is to think of port cities. Products arrive on very large ships, are unloaded, catalogued, organized and prepared for continued transit.  It would be bad practice to levy customs and duties simply because the products arrived at that particular port. It would make more sense to allow the products to pass through without assessment, to instead be taxed at their ultimate destination.

Substitute property taxes for customs and duties and you have the “freeport” exemption.

So Outdoor Cap made a mistake when it filed its personal property taxes and now wants some of its money back.

Benton County said “no.”

Outdoor Cap kept pursuing this until it wound up in the Arkansas Supreme Court.

The first thing that occurred to me is that perhaps Outdoor Cap was outside the refund period – you know: the “statute of limitations.” You have to get a refund claim in within a certain period of time, because to keep the claim period open indefinitely would impair the administration of the tax system

I was wrong. This was not about the statute of limitations. This was about whether Outdoor Cap paid something that the state was required to repay.

Outdoor Cap made three arguments:

            (1) The property was exempt from taxation.

The property is not taxable because of the freehold, but does that mean that the property is “exempt?’

And we now enter the legal swamp of wordsmithing. Technically, under Arkansas law (Ark Code Ann 26-26-1102) a freehold does not mean that the property is not taxable. There are two steps before property can be taxed: first, the property must be taxable; second, the property must be located in Arkansas.

The Court determined that the freehold addressed the second test only: Arkansas did not consider the property as being in Arkansas. Had it been, it would have been taxable.

This is a fine weaving of words, but there it is. Outdoor Cap lost argument one.

(2) The property was erroneously assessed.

Arkansas law (Ark Code Ann 26-35-91) allows refunds only for erroneously assessed property.

 
Outdoor Cap of course argued that the property was erroneously assessed.

On first impression, this seems solid ground. Outdoor Cap argued that the property was misclassified and taxes were erroneously paid on it. Taxes have to be assessed before they can be paid. Otherwise, the tax would be paid voluntarily, which is nonsensical.

The Court made a distinction between an excessive assessment and an erroneous assessment. Outdoor Cap reported its property without claiming the freeport. There cannot be an erroneous assessment under law because the company did not provide all the information that Arkansas would need to realize that there was an error. Yes, the assessment was “excessive,” but it was not “erroneous.”

Outdoor Cap lost argument two.

(3)  Since tax was not actually due, the payment was a voluntary payment and the company wants its payment refunded.

Arkansas apparently allows for voluntary payments. What it won’t do is give you the money back, unless you can show that you are otherwise entitled to a refund.

This gets us back to what we said in argument (2): to get money back, one has to show that the taxes are “recoverable.” Arkansas allows only one definition of “recoverable”: there must have been an error in assessment.

Surely taxes can be recoverable if there was a mistake?

“The principle is an ancient one in the common law, and is of general application. Every man is supposed to know the law, and if he voluntarily makes a payment which the law would not compel him to make, he cannot afterwards assign his ignorance of the law as a reason why the State should furnish him with legal remedies to recover it back.”

In desperation Outdoor Cap tried a “Hail Mary,” arguing that it paid it taxes under “coercion,” because, if taxes were not paid, the County had the authority to take and sell the property.

“… the argument is without merit because every taxpayer would have been ‘coerced’ according to Outdoor Cap’s argument because every taxpayer would be subject to penalties if its taxes weren’t paid.”

The “Hail Mary” fell to the ground.

The Court decides that Outdoor Cap …

“… voluntarily paid its taxes for the years 2008 and 2009, and did not claim a manufacturer’s exemption for those years. It is presumed to have known the law and its rights under the law. Accordingly, we do not find error in the circuit court’s application of the voluntary payment doctrine….” 

Outdoor Cap lost argument three.

The Court finally decided there was no refund for Outdoor Cap.

My thoughts?

Technically, the Court was correct. It was an affront to common sense, however. I have been at this for thirty years, and I have yet to meet the first person who paid taxes “voluntarily.” I guess I could put it on my bucket list, along with “play in the NFL.”

As I have gotten older, I have come to view the presumption that one “know the law” to be the drool of a political overclass.  An army of attorneys could not keep track of every mandate, ordinance, diktat or regulation these politicians strew upon society. It might be more honest if they simply said “I win and you lose, because I say so.”

I think Outdoor Cap Co got hosed.

New Plan for U.S. Expats to Comply With The IRS

There is good tax news for many U.S. expats and dual citizens. Beginning September 1^st, the IRS is starting a new program allowing many expats to catch-up on late tax returns and late FBARs without penalties.

This new program is different from the “Offshore Voluntary Disclosure” programs of the last few years. For one thing, this program is more geared to an average expat. Secondly, and more important to the target audience of the OVD programs, this program does not offer protection from criminal prosecution. That is likely a nonissue to an average expat who has been living and working in a foreign country for several years and has not been trying to hide income or assets from the U.S.

Under this new program, an expat will file 3 years of income tax returns and 6 years of FBARs. This is much better than the 8 years of income tax returns and 8 years of FBARs for OVD program participants.

All returns filed under this program will be reviewed by the IRS, but the IRS will divide the returns into two categories:

Low Risk – These will be simple tax returns, defined as expats living and working in foreign countries, paying foreign taxes, having a limited number of investments and owing U.S. tax of less than $1,500 for each year. Low risk taxpayers will get a pass – they will pay taxes and interest but no penalties.

NOTE: When you consider that the expat will receive a foreign tax credit for taxes paid the resident country, it is very possible that there will be NO U.S. tax.

 Higher Risk – These will be more complicated returns with higher incomes, significant economic activity in the U.S., or returns otherwise evidencing sophisticated tax planning. These returns will not qualify for the program and (likely) will be audited by the IRS. This is NOT the way to go if there is any concern about criminal prosecution. However, it MAY BE the way to go if concern over criminal prosecution is minimal. Why? The wildcard is the penalties. Under OVDP a 27.5% penalty is (virtually) automatic. Under this new program the IRS may waive penalties if one presents reasonable cause for noncompliance.

NOTE: This is one of the biggest complaints about the OVD program and its predecessors: the concept of “reasonable cause” does not apply. The IRS consequently will not mitigate OVD penalties. This may have made sense for multimillionaires at UBS, but it does not make sense for many of the expats swept-up by an outsized IRS dragnet.

The IRS has also announced that the new program will allow resolution of certain tax issues with foreign retirement plans. The IRS got itself into a trap by not recognizing certain foreign plans as the equivalent of a U.S. IRA. This created nasty tax problems, since contributions to such plans would not be deductible (under U.S. tax law) and earnings in such plans would not be tax-deferred (under U.S. tax law). You had the bizarre result of a Canadian IRA that was taxable in the U.S.

QUESTION: If your tax preparer had told you that this was the tax result of your Canadian RSSP, would you have believed him/her? Would you have questioned their competency? Sadly, they would have been right.

Taxpayer Advocate Issues Directive to IRS Commissioner

I am starting to like Nina Olson, the National Taxpayer Advocate.

I have been negative on the IRS program called the Offshore Voluntary Disclosure Program (OVDI).  This was the government reaction to the UBS and offshore bank account scandals. That however was tax fraud committed by the extraordinarily wealthy.  My background has been the Foreign Service and expat community, primarily because my wife is the daughter of a (retired) Foreign Service officer. These are rather ordinary folk who just happen to live overseas.

Tax advisors who work this area know that the IRS pulled a bait-and-switch a year ago - on March, 2011 - with taxpayers trying to comply with the freshly-resurrected foreign reporting requirements.  The FBAR has, for example, been out there since at least the early 70s, but at no time did Treasury want to confiscate 50% or more of your highest account balance for not filing a one-page form. The IRS was waist-deep with 2009 OVDI and had previously encouraged taxpayers to enter the program with lures of reduced penalties for non-willful violations.

EXAMPLE:  You have expatriated to Costa Rica. You have next-to-no ties in the United States and pay little attention to tax developments here. You have even learned to like soccer (but why?). The requirement to file an FBAR comes as quite the surprise to you. You first thought it absurd that such reporting would apply to the most ordinary of taxpayers. Surely that is for rich people only. You have to qualify as non-willful, right?

Then last March the IRS trotted-out a memo directive that it would not consider non-willfulness, reasonable cause, or the mitigation guidelines in applying the offshore penalty. Let me phrase that a different way: the IRS instructed its examiners to assume that the violation was willful unless the taxpayer could prove that it was not. Would you further believe that, at first, the memo was kept secret?

Huh? Are you kidding? O.J. Simpson received more “benefit of the doubt” than the IRS was willing to provide.

Then in August Nina Olson issued a Taxpayer Advocate Directive ordering IRS division commissioners to revoke this position and direct examiners to live up to their own promises to thousands of affected taxpayers.  The IRS division commissioners blew her off.

What?

Tax Analysts now reports that the main IRS commissioner – Douglas Shulman – has no intention of responding to Nina Olson on this matter. To aggravate the matter, there is a statutory requirement that the IRS commissioner respond to the Taxpayer Advocate within 90 days.  Do laws mean nothing to this crowd?

Is this a specialized tax area? Yes. Does it have greater import? I believe it does. It does because the tax attorney and tax CPA community – people such as me – pay attention, and this behavior diminishes confidence in the IRS and any trust in its word. The consequences are subtle, injurious and lasting. And for what purpose? To extract a penalty from someone whose only crime was not paying attention to increasingly obscure and inane U.S. tax law?

Employee or Contractor? There Is a New IRS Program

One of my individual tax clients came in around ten days ago. He brought his 2010 tax information, including a cleaning business reported as a proprietorship (technically it is a single-member LLC). I noticed that his payroll stopped somewhere during quarter 4, 2010. This of course prompted the question: why?

I suppose I did not need to ask. I have heard it before: the payroll taxes, including workers compensation, were becoming expensive. He consequently moved everyone over to a “Form 1099,” figuring that would solve his problem.

Let’s go through the steps: (1) If you can control and direct them, they are not contractors – they are employees; [2] removing them from payroll does not make them contractors; [3] issuing a 1099 at the end of the year (which he did not do, by the way, because I would have done it) does not make them contractors; and [4] a very important person – the IRS – may disagree with your opinion that they are contractors. If they disagree, the IRS may want the payroll taxes from you anyway. You would have gained nothing except an IRS audit and my professional fee for representing you.

Yep, I got stern with my client. I do not like dumb, and what he did was dumb. Payroll tax problems can get very messy – and absurdly expensive - very fast. I told him to restart the payroll.

The reason for this story is that the IRS came out this month with a “Voluntary Classification Settlement Program.” The program allows employers a chance to reclassify independent contractors and limit their resulting federal payroll taxes. To participate one must have consistently treated the individuals as contractors (that would eliminate my client) and have filed all Forms 1099 (again eliminating my client). One cannot currently be under audit, as there is a separate program for those under audit. One also has to agree to extend the statute of limitations assessment period for each of the three years going forward.

In return, one gains a substantial tax break. Before explaining, I would like to review Section 3509 of the Internal Revenue Code:

3509(a)In General.— If any employer fails to deduct and withhold any tax  … with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for—

3509(a)(1)Withholding taxes.— Tax … for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages…paid to such employee.

3509(a)(2)Employee social security tax.— Taxes … with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph.

Let’s go over the math:

                                Employer share of FICA                             7.65%

                                Employee share of FICA                            1.53%  (i.e., 7.65% times 20%)

                                Employee federal income tax                  1.50%

                                                                                                      10.68%

So that reclassification is going to cost you an immediate 10.68%, plus penalties and interest.

The new program will allow one to

·   pay 10% of the tax otherwise due, which is 1.07% (10.68% times 10%)

·   limited to one year

·   no interest or penalties, and

·   the IRS will not conduct an employment tax audit with respect to one’s worker classification for prior years.

This is a pretty good deal.

Remember that the IRS’ new position (although they deny it) is that virtually anyone who does anything for anybody is an employee. Please remember to fork-over that social security tax, thank you. If you are “walking the line” on worker classification, please consider this program.

United States v. Michael F. Schiavo

Let’s look at the matter of Michael Schiavo (United States v. Michael F. Schiavo). He was a bank director in Boston and had invested in a medical device partnership. This partnership had monies overseas. Schiavo decided to tuck the money (approximately $100,000) away and not tell anyone. He did not report the income and certainly did not file the Foreign Bank and Financial Accounts report (FBAR) with the Treasury on or before June 30 every year.

The partnership gave him about $100,000 in Bermuda to play with. He failed to file the FBARs for 2003 through 2008, so he was playing for a while.

He notices what the government was doing with UBS, meets with his advisor and decides to do a “quiet disclosure.” This means that he either amends his income tax return, files the FBAR, or both, without otherwise bringing attention to it. That is, it’s “quiet.”

The IRS had offered an amnesty program for foreign-account taxpayers back in 2009. The advantage was that the government would not prosecute. The downside was that there would be income taxes, penalties and a special 20% penalty for not having reported the monies originally. This program expired in October, 2009. Schiavo decided this was not for him.

The IRS has introduced another amnesty program in 2011, again allowing foreign-account taxpayers to come clean. This time the program covers two more years, and the penalties have been increased to 25% (with some exceptions). The IRS wants to increase the burden to the taxpayer so as not to reward the earlier act of noncompliance.

So Schiavo prepares and files FBARs for 2003 through 2008 but does not participate in the amnesty. That is, he is “quiet.” An IRS special agent then contacts him, whereupon Schiavo amends his income tax return to include the unreported income he just reported to the IRS via the FBAR.

You read this right. He made a quiet disclosure to the IRS but did not amend his income tax return to include the income he had just alerted them to.

The IRS estimates that the taxes at play were about $40,000.

Schiavo was convicted. He now faces a fine and possible jail time.

You are going to take this kind of risk for $40,000 in tax? Are you kidding me? You cannot retire on $40,000. Heck, one can barely send a kid to two years of college for $40,000. What was this guy thinking?