Navigating the New Tips Deduction: Brace Yourselves

The Tips Deduction

For the 2025 through 2028 taxable years, eligible taxpayers may be able to deduct up to $25,000 of qualified tips from taxable income on their return. To qualify, cash tips (including those paid in cash or charged on a card) must be received by an individual in an occupation that customarily received tips before 2025 (addressed later in this article).
The tips must be voluntary and cannot be received in connection with a specified service trade or business (SSTB). The qualifying tips must be reported and separately stated on any of the following tax forms:

• W-2,
• 1099-NEC,
• 1099-K, or
• Form 4137, Social Security and Medicare Tax on Unreported Tip Income

For the 2025 taxable year, the IRS has stated that it will not modify the W-2 to state qualifying tips separately. Instead, taxpayers should use the Social Security Tips listed in Box 7. This still leaves an open question regarding tips received by a sole proprietor, who can have qualifying tips for the deduction, but will not have such tips separately stated on the 2025 Form 1099-NEC or 1099-K. 

Congressional Limitations

Taxpayers with MAGI exceeding $150,000 ($300,000 MFJ) will see their tips deduction begin to phase out. MAGI is simply the taxpayer’s AGI after adding back any excluded foreign income. Taxpayers using the MFS filing status are generally not eligible unless they meet special requirements to be considered unmarried.

Proposed Regulations from the IRS

On September 22, 2025, the IRS released proposed regulations aimed at clarifying ambiguities and fulfilling its role under the code in guiding the administration of this new deduction.

Cash tips are defined as voluntary amounts received from customers, including tip-sharing arrangements and tip pools, that are paid by cash, check, credit card, debit card, gift card, casino chips, or any other form of electronic settlement or mobile app payment denominated in cash. However, they do not include event tickets, meals, services, or most digital assets.

Qualified tips must be voluntary. Service charges, auto gratuities, or other mandatory fees added to a customer’s bill are not qualifying tips for the tips deduction. However, if a customer can modify their service charge by subtracting from it or adding to it on their final bill, to the extent they can modify that payment, it is considered to be voluntary.

SSTBs are ineligible. Many tax professionals are aware of the rules for what businesses are considered SSTBs for the purposes of the Qualified Business Income (QBI) deduction. Any SSTB for QBI is also an SSTB for the tips deduction. However, the regulations clarify that if a taxpayer is an employee performing an SSTB activity for a hiring company which is NOT an SSTB, that taxpayer may claim the tips deduction.

In the proposed regs, the IRS provides an example of a pianist who is an employee of a hotel. Typically, a pianist is a performing artist who would be considered to be in an SSTB. However, because the hotel is not an SSTB, the tips the pianist receives while performing at the hotel as an employee of the hotel are eligible for the deduction. If, however, the pianist was a contractor (not an employee) and received tips while performing at the hotel, those tips would not be eligible for the deduction (because performing artists are SSTBs).

SSTB ineligibility was written into the law by Congress, and while the IRS guidance on the matter is helpful, it may lead to confusion for both taxpayers and practitioners. Clients who are accustomed to paying only a few hundred dollars for their tax return may be surprised when their tax preparation bill increases due to the questions that must be addressed when calculating eligibility for, and the amount of, the tips deduction.

To see a complete list of professions that customarily received tips before 2025, see IRS Proposed Regulation §1.224-1(f) or view the PDF posted by the IRS here.

(starting at page 33 of 45 in the PDF, or page 514 of the bulletin release)

Note that there are various professions listed within the document that are considered to be SSTBs. We will review this list in depth at our Update for 2025 Returns seminar to show when a given profession within the list may be ineligible due to the employer being engaged in an SSTB.

Interesting Conundrums Remain

Odd Rules for Odd Professions. In the proposed regulations, the IRS states that taxpayers engaged in illegal activities, prostitution, or pornography are ineligible to receive a tips deduction. While Congress did not initially include this provision in the law, it granted the IRS broad powers to exclude tips through “other requirements” under IRC §224(d)(2)(C).

Historically, rules like these have often been overlooked by many tax professionals. Still, in the age and era of applications like OnlyFans, it is not uncommon for tax professionals to have at least one client engaged in some form of pornography. The IRS dos not define what pornography is within the proposed regulations, so it will be interesting to see where the line is drawn.

In the past, under what was known as Chevron deference, the courts would generally defer to an agency’s interpretation in cases where statutes were ambiguous. This was recently overturned by the Supreme Court in a case called Loper Bright, which means that the courts no longer must follow agency guidance in their decisions. Since it is the IRS guidance and not the statute itself that dictates these new rules (denial of deduction for illegal activities, prostitution and pornography), we may soon see a tax court case where an OnlyFans model claims that these rules are invalid using Loper Bright.

Application of Rules for the Self-Employed. The IRS did not state in its proposed regulations how sole proprietors or other self-employed individuals should handle the reporting of qualified tips in 2025. Congress provided relief for the 2025 taxable year with respect to separately stating tips on Form 1099-NEC and 1099-K. Whether a sole proprietor can keep track of tips separately for 2025 is an open question. However, many sole proprietors today, such as those running DoorDash and Uber, will find that they can access the portion of their income that came from tips within their delivery application.

S Corporations Receiving Tips. One of the questions we’ve been asked numerous times over the months since OB3 was passed is whether S corporation shareholders are eligible for a tips deduction. It appears that because the deduction must be claimed on the individual return, any qualifying tips received by the S corporation must be reported to the Shareholder in Box 7 of the W-2. However, this has yet to be confirmed by the IRS.

Uncertainty Looms

We will be watching for more guidance on this and the other new deductions that will be available to taxpayers for 2025 returns. For the most up-to-date information, and in-depth analysis of all the new OB3 provisions, be sure to join us for our Update for 2025 Returns.