Read more

Marital status determines the filing status options available. Taxpayers determine their marital status on the last day of the tax year, unless their spouse died during the tax year, when they use their status on the date of the spouse’s death.

For unmarried taxpayers, the three options are:

1. Single,

2. Head of household (HOH), or

3. Surviving spouse.

For married taxpayers, the three options are:

1. Married filing jointly (MFJ),

2. Married filing separately (MFS), or

3. Head of household (if considered unmarried under §7703(b) or married to a nonresident alien under §2(b)(2)(B)).

The surviving spouse filing status is relatively uncommon. The IRS used to use the term qualifying widow(er), but now uses the term qualifying surviving spouse (QSS).

Surviving Spouse Benefits

The surviving spouse filing status key benefits include the use of the MFJ tax brackets (§1(j)(2)(A)) and the MFJ standard deduction amount (§63(c)(2)(A)(ii)). Whether a surviving spouse gets MFJ benefits under any other provision depends on the structure of that specific Code provision.

For example, with respect to the §24 child tax credit modified adjusted gross income (MAGI) phase-out, §24(h)(3) states: “…the threshold amount shall be $400,000 in the case of a joint return ($200,000 in any other case).” The surviving spouse child tax credit begins to phase out at $200,000 of MAGI.

On the other hand, with respect to the 3.8% net investment income tax, §1411(b)(1) states that the MAGI threshold amount “in the case of a taxpayer making a joint return under section 6013 or a surviving spouse (as defined in section 2(a)), $250,000.” The surviving spouse uses the MFJ threshold in this case.

Surviving Spouse Requirements

A surviving spouse must meet three requirements under Treas. Reg. §1.2-2(a)(1):

1. Their spouse died during either of the two tax years immediately preceding the tax year, and they were eligible to file a joint return in the year of death,

2. They maintain a home as a household that, for the tax year, is the principal place of residence for a son, stepson, daughter, or stepdaughter, and

3. They claim the son, stepson, daughter, or stepdaughter as a §151 dependent.

Example

Travis’s first wife died in 2016 while married to him. Travis married his second wife in 2018, who then died in 2019. Travis remained unmarried after that time. Over the years, Travis had a young son whom he maintained in his household and claimed as a dependent.

In 2016, Travis could file MFS or MFJ, but in 2017, he is eligible for QSS.

In 2018 and 2019, Travis could file MFJ or MFS, but in 2020 and 2021, he is eligible for QSS.

In the tax years Travis qualifies for QSS, he also qualifies for HOH; however, it is almost certain that QSS would result in the lowest tax liability.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

…must advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.

The client, not the practitioner, must decide whether to correct the error:

• It is inappropriate to prepare an amended return, send it to the client, and let them decide what to do with it. Our ethical obligation is to provide advice.

• The advice provided to the client should be documented in the client's file. Tom’s Tax Toolbox has a new template available for this documentation.

• The practitioner must decide whether to engage a client who will not address tax return errors; there may be risks in future engagements.

Errors that Generate a Refund

An amended return with a refund must be filed within the refund statute of limitations in order for the amount to be refunded. Learn more about the refund statute of limitations in this article.

Errors that Generate a Balance Due

An amended return with an increase in tax must be filed within the assessment statute of limitations; otherwise, the IRS is barred from processing it. Learn more about the assessment statute of limitations in this article.

If the client decides to correct the error, they can submit a qualified amended return and avoid §6662 accuracy-related penalties on the additional tax, provided that the amount is not related to a fraudulent position on the original return.

Under Treas. Reg. §1.6664-2(c)(3), a qualified amended return is an amended return filed after the due date of the return (including extensions) and before the earliest of the following events:

1. The date the taxpayer is first contacted by the IRS concerning any examination (including a criminal investigation) with respect to the return,

2. The date any taxpayer is first contacted by the IRS concerning an examination of that taxpayer for claiming an abusive tax shelter benefit,

3. The date a pass-through entity is first contacted by the IRS in connection with an examination of the return to which the pass-through item relates,

4. The date on which the IRS serves a §7609(f) John Doe summons relating to the tax liability of a person, group, or class that includes the taxpayer with respect to an activity for which the taxpayer claimed any tax benefit on the return, and

5. The date on which the IRS announces guidance published in the Internal Revenue Bulletin a settlement initiative to compromise or waive penalties, in whole or in part, with respect to a listed transaction if the taxpayer who participated in the listed transaction and for the taxable year(s) in which the taxpayer claimed any direct or indirect tax benefits from the listed transaction.

In most circumstances, a qualified amended return is one filed prior to the date that the IRS contacts a taxpayer regarding an examination of that tax year.

A return filed on or before the due date of the return (unextended or extended) is not a qualified amended return but instead is a superseding return. I wrote about superseding returns in this article..

Qualified Amended Return Example

A client’s 2023 tax return has an erroneous $25,000 Schedule C deduction that created a $22,000 loss. It is not a trade or business activity, so the $3,000 of income should be reported as other income on Form 1040, and no deductions are allowed. Assume that the taxpayer is in the 24% tax bracket.

If the taxpayer uses a qualified amended return to proactively fix the tax return issue, and the taxpayer files and pays the balance due on May 1, 2025, then the correction costs the client $6,500: $6,000 in additional tax, $500 in interest on the additional tax, and no §6662 accuracy-related penalties.

If the IRS finds the error in a correspondence examination and makes the assessment on May 1, 2026, then the changes will total $8,165:

• $6,000 in additional tax,

• $965 in interest on the additional tax, and

• $1,200 in §6662(b)(2) accuracy-related penalties.

Interest will continue to accrue on the tax balance until the taxpayer pays the additional tax or posts a §6603 deposit.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

Value Pricing Defined

Value pricing anchors the fee to the anticipated value the engagement delivers to the client. While value is primarily economic, it can also include intangible benefits. Examples of value include anticipated tax savings, avoided penalty and interest exposure, reduced risk, access to expertise, and peace of mind.

Any pricing method can use value pricing principles. Hourly, fixed-fee, or subscription pricing can all incorporate a value framework.

Value pricing is impossible without a real pre-engagement discovery process. A practitioner cannot price an engagement they do not understand. The practitioner should inquire about answers to the following questions:

• What is the problem the client is actually trying to solve?

• What does an ideal outcome look like for them?

• What is the cost of doing nothing, or of getting this wrong?

• What risks are they carrying that they may not know about?

• What have they tried before, and how did it turn out?

• Is there a timeline driving the engagement?

Why Value Pricing Works

Value pricing severs the link between time and price. High-impact work, such as advisory services or IRS representation services, is priced commensurate with its actual value to the client, and the practitioner is rewarded for expertise rather than for the time or effort required to complete it. A practitioner who can resolve a complex penalty matter in two hours of focused thought, drawing on twenty years of experience, is not punished for their knowledge, skill, and efficiency in a value pricing model, since the practitioner's inputs do not drive the fee.

A practitioner who embraces value pricing must naturally position themselves as a strategic advisor, not a transactional service provider. This distinction matters increasingly as basic compliance work gets completed by AI and automation.

Meeting revenue goals with fewer clients leaves room to do each engagement thoroughly and properly, directly supporting the Circular 230 §10.22 due diligence obligation, a duty that does not adjust based on the practitioner’s fee.

Where Value Pricing May Not Fit

Value pricing does not work if the practitioner cannot clearly articulate the engagement’s economic value; for example, Form 1040 preparation, payroll services, and bookkeeping services may not be ideal for value pricing. The better option is to bundle compliance services into a broader, value-priced engagement.

Value pricing demands skills that not every practitioner has or wants to develop. A value-pricing conversation requires real discovery, a willingness to articulate value in dollar terms without flinching, and the discipline to hold the price when a client pushes back rather than dropping the fee to save the engagement. Practitioners trained to justify fees by time spent may find this conversation uncomfortable, and clients sense that discomfort.

Value Pricing is Not a Contingent Fee

Under Circular 230 §10.27(b), a practitioner generally may not charge a contingent fee in connection with IRS matters. The exceptions are examinations of an original return (or a timely-filed amended return or refund claim), penalty and interest abatement claims, and judicial proceedings under the Internal Revenue Code.

§10.27(c)(1) defines contingent fees broadly. It captures any fee based on whether a position is sustained, the refund or tax saved, or a specific result attained. It also includes arrangements that are contingent in substance, such as rebates, indemnity guarantees, rescission rights, and similar provisions.

Value pricing avoids this characterization because the fee is determined by the anticipated value rather than the realized outcome. A value-priced engagement includes anticipated savings as one input into setting the fee, but once set, the fee does not change based on the engagement outcome.

Example. A taxpayer was assessed a $42,000 §6662 accuracy-related penalty and has a very strong case for penalty abatement due to reasonable cause. An example of a contingent fee is 20% of the penalty reduction received, and an example of a value-priced fixed fee is $7,000 for the engagement, regardless of the outcome.

Tom’s Three-Factor Value Pricing Model (For Paid Subscribers Only)

Read more

The transit of the activity from the decedent to the estate to the beneficiary has three distinct considerations with how to handle PALs and current losses from the activity.

Issue #1: Death

Under §469(g)(2), when a taxpayer dies holding a passive activity with suspended losses, those losses are not fully released to the final Form 1040. Only the PALs that exceed the §1014 step-up in basis attributable to the activity are deductible on the decedent’s final return. The remaining losses (the portion covered by the step-up) are permanently disallowed. They do not transfer to the estate or to the beneficiaries.

Final Form 1040 Deductible PAL = Total Suspended PALs − §1014 Basis Step-Up

The logic is not hard to follow: the §1014 step-up eliminates the built-in gain those losses would have offset on a future sale. Allowing both the step-up and the loss deduction would be a double benefit, and Congress said no.

Example: An S corporation shareholder dies with $50,000 of PALs that originated from the S corporation stock. Upon death, the S corporation stock received a step-up in basis to FMV, which increases the stock basis by $30,000. On the decedent’s final Form 1040, $20,000 of the losses are deductible, and the remaining $30,000 are lost.

Issue #2: Estate Administration

The estate takes the passive activity interest with the stepped-up basis. From that point forward, the estate accumulates its own suspended PALs based on whether the executor materially participates in the activity. See S. Rep’t No. 313, 99th Cong., 2d Sess. 735 (1986), 1986-3 C.B. 735.

In practice, executors rarely satisfy the material participation tests; the activity almost always defaults to passive at the estate level. The losses incurred during estate administration are likely to be suspended until either the estate disposes of the activity or the estate terminates.

Issue #3: Estate Termination

When the estate terminates and distributes a passive activity interest to a beneficiary, §469(j)(12) governs. The estate’s suspended PALs allocable to the distributed interest increase the beneficiary’s basis in that interest. The losses are not deducted by the estate or passed through to the beneficiary.

One more point worth making explicit: the beneficiary’s future material participation in the activity is irrelevant to the §469(j)(12) analysis. The beneficiary’s future participation status governs the treatment of future losses from the activity.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

Read more

The Kwong holding logically extends to most other filing and payment deadlines that began on January 20, 2020, and ended on July 10, 2023, opening the door to a refund or an abatement of any penalties or interest that accrued during that period.

While there is no statute of limitations on an abatement request for an unpaid amount (assuming the collection statute of limitations has not expired), the refund statute of limitations does apply to a Kwong claim. Read more about it in this prior article:

Recent Law Change Opens the Door to Refund Claims

New §7508A(f), which was added to the Code in the Disaster Related Extension of Deadlines Act (P.L. 119-64), provides that for purposes of the §6511(b)(2)(A) three-year lookback period, any period disregarded under §7508A shall be treated as an extension of time for filing the return. The COVID postponement period is now added to the three-year lookback window, ensuring that timely refund claims result in actual refunds. Two important notes about this rule:

1. It only applies to refund claims filed after December 26, 2025, and

2. It does not apply to refund claims in which the refund amount is limited to the amount paid in the two years immediately preceding the claim.

Practical Kwong Example

Daisy filed her 2021 Form 1040 on August 8, 2022. As a result of filing late, she was assessed $22,502 in §6651(a)(1) late-filing penalties, §6651(a)(2) late-payment penalties, and interest, which Daisy fully paid on September 12, 2022.

Under the Kwong holding, §7508A postponed the deadlines for the 2021 Form 1040 filing and the payment of any balance due to July 10, 2023; therefore, the penalty and interest assessments were erroneous, and the taxpayer is entitled to a refund.

Assume that Daisy files a refund claim on June 3, 2026 for $22,502.

Step 1 — §6511(a): Is the Refund Claim Timely? Without Kwong, the three-year period runs to August 8, 2025, and the two-year period runs to September 12, 2024. The later of the two dates is August 8, 2025, and a refund claim filed June 3, 2026, is not timely; no refund is allowed.

Applying the Kwong analysis, §7508A disregards the COVID-19 postponement period in computing the §6511(a) window, so the three-year period begins July 10, 2023, and runs through July 10, 2026. The refund claim filed on June 3, 2026 is timely.

Step 2 — §6511(b)(2)(A): What is the Refundable Amount? Without §7508A(f), the three-year lookback starting June 3, 2026 runs back only to June 3, 2023. The $22,502 was paid on September 12, 2022, and falls entirely outside the three-year lookback window. The claim is timely, but there are no refundable payments.

Applying §7508A(f), the COVID-19 postponement period is treated as an extension for three-year lookback period purposes:

1. The taxpayer filed the claim on June 3, 2026, so the normal three-year period runs back to June 3, 2023.

2. The period from August 8, 2022, to July 10, 2023, is 336 days, which extends the three years.

3. The extended three-year period runs to July 2, 2022.

Since the September 12, 2022 payment date falls within that expanded window, the refund claim filed on June 3, 2026 for $22,502 is entirely recoverable.

Next Steps

The IRS is likely to appeal Kwong to the Federal Circuit Court of Appeals; as such, a taxpayer with a Kwong claim should file a protective claim using Form 843, Claim for Refund and Request for Abatement. Internal Revenue Manual (IRM) 4.10.11.2.1.3(4) (09-04-2020) provides an excellent explanation of protective refund claims and their essential elements:

In some instances, a claim may be filed by the taxpayer in anticipation of an expected change in the tax law, other legislation, regulations, case law, or other contingency. A “protective claim” is a claim for credit or refund filed by the taxpayer to preserve the right to pursue a refund based on the resolution of an issue contingent on future events that may not be determinable until after the refund statute has expired. Taxpayers file protective claims to ensure they meet the timeliness requirement. With regard to the requirements of form and content, a protective claim must be in writing, include the taxpayer’s name, address, TIN and signature, identify the contingency affecting the claim, be sufficiently clear and definite to alert the IRS as to the essential nature of the claim, and identify the specific year(s) for which the refund is sought. The exact amount of refund requested may not be known at the time the claim is filed…

IRM 25.6.1.10.3.2.5 (07-05-2024) states the IRS has discretion in how to process protective refund claims:

…A valid protective claim need not state a particular dollar amount or demand an immediate refund; however, the claim must identify and describe the contingencies affecting the claim; must be sufficiently clear and definite to alert the IRS as to the essential nature of the claim; and must identify a specific year or years for which a refund is sought.

The IRS has discretion in deciding how to process protective claims. In general, it is in the best interests of the IRS and taxpayers to delay action on protective claims until the pending litigation or other contingency is resolved. Once the contingency is resolved, the IRS may obtain additional information necessary to process the claim and then allow or disallow the claim.

Be sure to address the following in the Form 843 explanation:

• It is a protective claim due to Kwong v. United States, 179 Fed. Cl. 382 (2025),

• Why §7508A applies to the situation to warrant penalty and/or interest removal,

• The claim amount calculation, if needed (using a tool like TaxInterest), and

• How the claim is timely under the refund statute of limitations.

The work in determining eligibility for these claims is significant, as is the uncertainty of processing. But, on the other hand, they can be extremely lucrative to clients if other courts uphold Kwong. Practitioners may want to consider a hybrid fee model: a flat, upfront fee to file the claim, plus a contingent fee if the IRS issues the refund.

Circular 230 §10.27(b)(3) permits contingent fees “for services rendered in connection with a claim for credit or refund filed solely in connection with the determination of statutory interest or penalties assessed by the Internal Revenue Service.”

Sample Kwong Refund Claim

Tom’s Tax Toolbox contains a sample Form 843, Claim for Refund and Request for Abatement, for a Kwong refund claim for a §6654 estimated tax penalty.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

While politicians refer to this provision as “no tax on Social Security,” the deduction is unrelated to a taxpayer’s receipt of Social Security benefits.

The senior deduction does not reduce AGI but does reduce taxable income; it can be claimed regardless of whether the taxpayer itemizes deductions. The deduction is available for tax years 2025 through 2028 on Schedule 1-A, Additional Deductions.

Age Determination

For purposes of determining a taxpayer’s age, they are considered to have attained their age on the day before their actual birthday. If a taxpayer died in 2025, they must have lived until they attained age 65. See the 2025 Form 1040 Instructions, p. 110.

Example. Abel was born on February 14, 1960, and died on February 13, 2025. He is considered age 65 at the time of death and would qualify for the senior deduction for tax year 2025. However, if Abel died on February 12, 2025, he would not have attained age 65 in tax year 2025 and would not qualify for the senior deduction.

Deduction Phase-Out

The $6,000 deduction is reduced by 6% of modified adjusted gross income (MAGI), to the extent it exceeds $75,000 ($150,000 on a joint return), and is not reduced below $0. On a joint tax return with two individuals aged 65 and older, each $6,000 amount is phased out separately, so the deduction is completely phased out at $250,000 AGI. MAGI is AGI plus amounts excluded under §911, §931, or §933.

Example. In tax year 2025, Gerald is 88, and Samantha is 62, and they filed a joint return with MAGI of $175,000. Their senior deduction is $4,500, which is $6,000 less $1,500 (6% of $25,000, the amount their MAGI exceeds $150,000).

Example. Troy and Harris are married and file a joint return. In tax year 2025, Troy is 68 and receiving Social Security benefits, and Harris is 65 and not receiving Social Security benefits. Their 2025 MAGI is $205,220. They both qualify for the senior deduction at a reduced amount, even though Harris has not yet applied for Social Security benefits. Their combined senior deduction is $5,374 as calculated below:

Additional Deduction Requirements

The taxpayer must include their SSN on their tax return. The SSN must be valid for employment and issued before the due date of the tax return (including extensions). The omission of the SSN is treated as a mathematical or clerical error for which the IRS has the authority to adjust the return without a notice of deficiency being issued.

If married, the taxpayer must file a joint tax return to claim the deduction; it is not available on a married filing separately return.

2026 Tax Planning Considerations

If the taxpayer’s MAGI will limit or eliminate the senior deduction, consider strategies to reduce the 2026 MAGI (e.g., accelerate deductions, defer income, retirement distribution planning). Taxpayers greater than age 70.5 should consider tax-free qualified charitable distributions (QCDs) to meet their charitable goals and/or required minimum distribution (RMD) requirements.

The taxpayer’s AGI in tax year 2026 will affect their Medicare IRMAA surcharges in tax year 2028. While the 2028 IRMAA thresholds are not known, they will most likely overlap with the upper end of the senior deduction phase-out range.

If a taxpayer’s income is insufficient to use all the deductions that they are entitled to (e.g., standard/itemized deductions, senior deduction), they should consider accelerating income to tax year 2026 to utilize these deductions (e.g., Roth conversions, traditional IRA distributions, capital gain harvesting). Be careful to track the effect on AGI to avoid losing any positive tax attributes.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

While it is best to file any 2022 Form 1040 returns before April 15, 2026 to avoid issues, many individuals may qualify for an exception that allows for a full or partial refund if the original 2022 return is filed after that date.

Why April 15, 2026 is the General Deadline

Under §6513(b)(1) and §6513(b)(2), withholding taxes and estimated tax payments for tax year 2022 are deemed paid on April 15, 2023. For any of those amounts to be refundable, April 15, 2023 must fall within the three-year period immediately preceding the filing of the original 2022 return; thus, it must be filed by April 15, 2026. See §6511(b)(2)(A) and Rev. Rul. 76-511.

Exception #1: Extension Filed

If an individual received an automatic six-month extension of time to file, they have until October 15, 2026 to file the 2022 Form 1040 to get a full refund because the extension period is added to the three-year lookback period. See §6511(b)(2)(A) and Internal Revenue Manual 25.6.1.10.3.3(2), row 6 (12-10-2024).

Example. Tamika files an original delinquent 2022 Form 1040 claiming a refund. She received a six-month extension of time to file the 2022 return. She files the return on May 15, 2026, and her refund is from withholding tax, which is deemed paid on April 15, 2023. Since April 15, 2023 falls within the immediately preceding three years plus the extension period, the refund is allowed. See Internal Revenue Manual 25.6.1.10.3.3.2.1(3)(b) (10-01-2025).

Exception #2: Post April 15, 2023 Payments

If an individual made payments to their 2022 Form 1040 account after April 15, 2023, those payments may be refundable if they fall within the three-year period immediately preceding the filing of the original return, as discussed earlier. However, any portion of the refund attributable to withholding tax or estimated tax payments may not be refundable.

Example. Hugo never filed his 2022 Form 1040 or an extension for that year. After receiving several IRS notices seeking the return, he paid $10,000 to the IRS on January 15, 2024, hoping the IRS would leave him alone. Hugo’s original 2022 return shows a $1,200 refund from withholding only; however, when the $10,000 payment is included, he overpaid $11,200 on the 2022 return.

If Hugo files his original 2022 return on or before April 15, 2026, he can receive a $11,200 refund (both from withholding and the voluntary payment).

If Hugo files his original 2022 return after April 15, 2026, but on or before January 15, 2027, he can receive a $10,000 refund from the voluntary payment; the refund from the withholding is outside the three-year lookback period and not refundable.

If Hugo files his original return after January 15, 2027, the amounts are not refundable since there are no refundable payments in the preceding three-year period.

Timely Postmark Counts

A claim filed on a delinquent original income tax return that is postmarked on the last day of the three years is deemed to be filed on the postmark date. See Internal Revenue Manual 25.6.1.10.3.3.1.4(3) (10-01-2025) and Treas. Reg. §301.7502-1(f).

It is best practice to mail these returns by certified mail, as the date of the U.S. postmark on the receipt retained by the sender is treated as the postmark date. See Treas. Reg. §301.7502-1(c)(2).

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

Read more

The IRS attempted to resolve the issue by issuing a §199A eligibility safe harbor; however, it was poorly designed and overly complex, further adding to the confusion. As a reminder, a safe harbor in the tax law is not a requirement to claim a tax benefit; it is a bright-line shortcut to apply a vague or subjective standard.

Missing the §199A deduction for rental activities remains a frequent error on returns that I review, so it is important to explain how to make this determination.

When Does a Rental Activity Qualify for the §199A Deduction?

Under Treas. Reg. §1.199A-1(b)(14), a rental activity qualifies for the §199A deduction in one of two ways:

1. It is a §162 trade or business, or

2. A commonly controlled trade or business is the lessee.

§162 Trade or Business

In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court said that for an activity to be a trade or business:

…the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.

In Higgins v. Commissioner, 312 U.S. 212 (1941), the Supreme Court said that the trade or business determination is dependent on the facts and circumstances of that taxpayer’s particular situation, which can make many tax professionals uncomfortable since it is not a bright-line test or standard.

In Service Center Advice 200120037, the IRS opined that most rental activities qualify as §162 trade or business activities, citing cases over the last 70 years:

Where it is clear from the facts that real estate is devoted to rental purposes, the courts have repeatedly held that such use constitutes use of property in a trade or business, regardless of whether or not it is the only property so used...

For example, in Hazard v. Commissioner, 7 T.C. 372 (1946), the Tax Court determined that the rental of a single residential property constituted a trade or business, even though the record contained no information about the owner's activity level.

The IRS acquiesced to the Hazard decision and has not changed its position that minimal activity is needed, as stated in General Counsel Memorandum 38779:

...the problem that you raise is not with the legal standard applied by the courts, but with the relatively small amount of activity that the courts have found to be indicative of a trade or business. In view of the number of cases that have been decided on this issue, only some of which have been cited above, it is unlikely that the Service could now persuade the courts to take a more restrictive approach with respect to the amount of activity required to find that a taxpayer’s rental activity constituted a trade or business.

The preamble to the final §199A regulations provided factors to consider when determining if a rental activity rises to a §162 trade or business:

• Type of rented property (commercial real property versus residential property)

• Number of properties rented

• The owner’s or the owner’s agent’s day-to-day involvement

• Types and significance of any ancillary services provided under the lease

• Terms of the lease (a net lease versus a traditional lease, and a short-term lease versus a long-term lease)

Examples of a rental activity that would typically not constitute a §162 trade or business:

• A single triple-net lease; however, it is possible that the rental of a triple-net lease property in conjunction with other rental activities could cause all of the rental activities to collectively rise to the level of a §162 trade or business. See Lewenhaupt v. Commissioner, 20 T.C. 151 (1953); CRSO v. Commissioner, 128 T.C. 153 (2007).

• A rental not engaged in for profit, considering the §183 regulations. For example, a significantly below-market rental amount to a family or friend, or a lease-back to the original owner of a residence as part of the sale of that residence.

Whether or not a rental activity is passive under §469 is not determinative of its §162 trade or business determination. A rental activity (or even a non-rental activity, such as ownership of a pass-through entity as a mere investor) can be both a passive activity and a §162 trade or business.

Rental Activity Safe Harbor

In September 2019, the IRS issued Rev. Proc. 2019-38 to provide a safe harbor for §199A determinations for rental activities; however, it is very restrictive and disadvantages small-scale rental property owners. As the safe harbor itself says:

If an enterprise fails to satisfy the requirements of this safe harbor, it may be treated as a trade or business for purposes of section 199A if the enterprise otherwise meets the definition of trade or business…

To meet the safe harbor, a taxpayer must demonstrate at least 250 hours of rental services across the “rental real estate enterprise” by owners, employees, agents, and/or independent contractors. There are complex rules on how to assemble one’s rental real estate enterprise(s), and the taxpayer must document hours, including those of their workers, to meet the safe harbor.

To reiterate: the safe harbor is optional. A rental activity that is a §162 trade or business qualifies for the §199A deduction regardless of the 250-hour rule.

Commonly Controlled Trade or Business Rental

A rental activity can fail to be a §162 trade or business and yet qualify for the §199A deduction if the taxpayer rents the property to a commonly controlled trade or business. Common control exists when the same person or group of persons, directly or by attribution under §267(b) or §707(b), owns 50% or more of both the rental activity and the §199A-eligible trade or business. See Treas. Reg. §1.199A-4(b)(1)(i).

If a rental activity qualifies for the §199A deduction under this provision, and the commonly controlled business is a specified service trade or business (SSTB), then that portion of the rental property being rented to the 50% or more commonly-owned SSTB is treated as a separate SSTB with respect to the related parties. See Treas. Reg. §1.199A-5(c)(2)(i).

Tom’s Thoughts (For Paid Subscribers Only)

Read more

There are important disclosure issues arising from the use of AI; therefore, it is important to review the law governing how tax professionals can disclose and use client tax information.

§7216 Overview

Under §7216, a tax return preparer who knowingly or recklessly discloses tax return information or uses tax return information for any purpose other than preparing or assisting in preparing a tax return, unless an exception applies, can be subject to a fine of up to $1,000, imprisonment of up to one year, or both.

These terms have specific definitions in Treas. Reg. §301.7216-1:

• A tax return preparer is typically any person engaged in the business of preparing or assisting in preparing tax returns, or providing auxiliary services in connection with their preparation. See Treas. Reg. §301.7216-1(b)(2).

• Tax return information is any information, including, but not limited to, a taxpayer’s name, address, or identifying number, which is furnished in any form or manner for, or in connection with, the preparation of a tax return of the taxpayer. Tax return information also includes information the tax return preparer derives or generates from tax return information in connection with the preparation of a taxpayer’s return. Even the fact that someone is a client can be tax return information. See Treas. Reg. §301.7216-1(b)(3).

• Disclosure of tax return information is the act of making tax return information known to any person in any manner whatever. See Treas. Reg. §301.7216-1(b)(5).

• Use of tax return information includes any circumstance in which a tax return preparer refers to, or relies upon, tax return information as the basis to take or permit an action. See Treas. Reg. §301.7216-1(b)(4).

There are many exceptions to the disclosure and use prohibitions; however, the tax return preparer must meet the strict requirements of each exception. Treas. Reg. §301.7216-2 lists the exceptions that do not require a taxpayer’s consent. Some examples include disclosures to the IRS, certain disclosures to other tax return preparers, certain disclosures to contractors, and certain disclosures for quality or peer review.

If an exception does not apply, the tax return preparer must get the taxpayer’s consent to disclose or use their tax return information, and Treas. Reg. §301.7216-3 lists the requirements to obtain consent from the taxpayer.

Rev. Proc. 2013-14 contains the required language, format, and procedures for obtaining consent for Form 1040 series returns. For all other taxpayers, the consent may be in any format, including an engagement letter to a client, provided it complies with all requirements. See Treas. Reg. §301.7216-3(a)(3)(iii).

Where AI Enters the Picture

With the legal framework in mind, let’s talk about what this looks like in practice when AI tools are involved.

Every AI tool operates on a simple model: you provide input, the tool processes it, and it generates output. That input typically does not remain on your machine. It travels to a server operated by the AI provider. In some cases, the input may be stored, logged, reviewed by human trainers, or used to improve future versions of the model.

When a tax return preparer enters tax return information into a third-party AI tool, that is a disclosure under Treas. Reg. §301.7216-1(b)(5) to another person, specifically the AI provider, and potentially to its employees, contractors, and systems.

This disclosure occurs regardless of the AI provider’s privacy promises. The §7216 analysis does not hinge on whether the provider retains or deletes the data; the disclosure occurred the moment the data left the tax return preparer’s control.

The scenarios below are not hypothetical — they are typical for tax return preparers.

The research question. A tax return preparation client tells you about a previously unreported foreign bank account. You're not sure how to approach the disclosure, so you open an AI tool and start working through it. Your first prompt is general enough: “What are the current options for resolving unreported foreign bank accounts with the IRS?” No client data, no issue. But then you want to get specific, so you follow up with: “My client, Sarah, is a pediatric dentist in Midland, making about $350,000. She has a UBS account in Zurich with roughly $120,000 that she hasn’t reported on FBARs or Form 8938 for the last five years. Can she qualify for Streamlined?” You started with a clean general question. Two messages later, you’ve given an AI provider your client’s name, a specific occupation in a small city, income, foreign bank details, and a non-filing position. This action is a §7216 disclosure.

The innocent shortcut. You paste three pages of notes from a tax return preparation client meeting into an AI tool and ask it to “summarize the key issues.” Those notes refer to the client by name, mention their spouse’s employer, list the estimated income from two rental properties, and repeatedly mention the name of the LLC that the spouses jointly own. This action is a §7216 disclosure.

But — “It’s Just Software”

A common objection: “How is this different from using tax preparation software? Drake has my client’s data.”

Tax preparation software serves a direct, necessary role in preparing the return, and disclosure to those providers generally falls under the auxiliary services exception in Treas. Reg. §301.7216-2(d). The software exists to prepare the tax return.

The use of ChatGPT, Claude, or another AI tool is unlikely to constitute an auxiliary service under Treas. Reg. §301.7216-1(b)(3)(iii); however, there is no guidance from the IRS. Some AI providers are developing tax-specific products with dedicated data-handling agreements, which require a different analysis, but this does not apply to the general-purpose AI tools most tax return preparers use today.

Consent Challenges for AI Tools

If no exception applies, the tax return preparer needs the taxpayer’s consent under Treas. Reg. §301.7216-3. For Form 1040 filers, the practitioner must follow Rev. Proc. 2013-14 to obtain valid consent; for all other taxpayers, the format may vary, provided the tax return preparer meets all requirements. In the context of AI tools, obtaining consent presents some specific challenges.

The consent must identify the recipient of the disclosure. “Various AI tools” is not sufficient. The tax return preparer needs to name the specific provider: OpenAI, Anthropic, Google, or whichever company operates the tool. A change in providers requires a new consent.

The consent must describe the tax return information to be disclosed. The tax return preparer must think carefully about what data will actually be entered into the tool, not just in general terms, but specifically enough for the client to make an informed decision.

The consent must state the purpose of the disclosure. “To help with your tax situation” is vague. A more defensible approach would describe the specific use: drafting correspondence, researching a tax position, etc.

The consent must include a statement that the taxpayer is not required to sign it. The client’s participation must be voluntary.

What About Redacted Data?

Many tax return preparers believe stripping the client’s name and Social Security number solves the problem. It helps, but it may not be enough.

Remember the regulatory definition: tax return information includes any information furnished in connection with the preparation of a tax return. If the combination of the remaining details could reasonably identify the taxpayer, the concern under §7216 would persist.

However, the more the tax return preparer sanitizes the data, the less useful the AI output becomes. That is a tension everyone using AI tools has to navigate.

Practical Steps

None of this means you should stop using AI. It means you need to use it deliberately.

Get proper consent. If you’re going to use AI tools with Form 1040 client data, build a standalone consent form that meets the requirements of Rev. Proc. 2013-14. Name the specific tools. Describe the data. Explain the purpose. Make the client’s choice voluntary. Get it signed before you disclose anything.

Sanitize before you type. Remove names, SSNs, EINs, addresses, and any other identifying information before entering anything into an AI tool. Be sure to change identifying details. If you’re drafting a penalty abatement request, “taxpayer” works just as well as the client’s name.

Know your provider’s policies. Read the terms of service and privacy policy for every AI tool you use. Key questions: Does the provider use your input to train future models? Can you opt out? Does the provider offer a business or enterprise tier with stronger data protections? Is there a data processing agreement available? These policies change frequently — check them regularly.

Document your process. Keep records of what tools you use, what consent you obtained, what data was entered, and what steps you took to protect client information. A documented, deliberate process is your best defense.

Update your WISP. Your written information security plan (WISP) should specifically address AI tools. Which tools are approved? Who is authorized to use them? What data can and cannot be entered? Under what circumstances? And remember, your obligations here aren't limited to §7216. The FTC Safeguards Rule, issued under the Gramm-Leach-Bliley Act, requires tax preparers to maintain comprehensive security programs that protect client information. That includes having written policies governing how new technologies are evaluated and adopted. If your WISP does not address AI, you have a problem.

The Bottom Line

AI tools offer real value to tax practitioners. The efficiency gains are significant, and the technology is only getting better. But the rules governing our use of client data do not disappear because the technology has changed.

Congress enacted §7216 in 1971, and the Treasury Department last updated its regulations in 2012. The current rules do not contemplate current technological advancements. But the same principle applies: clients trust us with their most sensitive financial information, and we have a legal and moral obligation to protect it.

While there is no specific IRS guidance on AI tools and §7216 yet, that absence does not mean a free-for-all is permitted. When in doubt, apply best practices: get consent, sanitize your inputs, know your tools, and protect your clients. The technology is worth using, but it is also worth using carefully.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

For tax year 2025, a taxpayer may claim a credit of up to $17,280 per eligible child. The credit applies to qualified adoption expenses, which include adoption fees, court costs, attorney fees, and other reasonable and necessary expenses directly related to the adoption. Expenses connected with adopting a spouse’s child do not qualify.

The credit works differently depending on the type of adoption:

• For domestic adoptions, expenses are generally creditable in the year after they are paid, even if the adoption is not final.

• For foreign adoptions, expenses are generally creditable in the year the adoption becomes final.

• For special needs adoptions, a taxpayer may claim the full credit amount in the year the adoption becomes final, regardless of the actual expenses paid.

The adoption credit is subject to income phase-outs. For tax year 2025, the credit begins to phase out when modified adjusted gross income (MAGI) exceeds $259,190 and is completely phased out at $299,190.

Before tax year 2025, the credit was nonrefundable; however, the taxpayer can carry forward unused amounts for up to five years.

Credit Now Partially Refundable

§70402 of the One Big Beautiful Bill Act (OB3 Act) provided that up to $5,000 of the adoption credit per child is refundable, effective for tax year 2025. The IRS’s original interpretation of this new provision, reflected in the current version of Form 8839, Qualified Adoption Expenses, is that a carry forward credit is not eligible for the refundable portion.

However, on Monday, March 9, IRS CEO Frank Bisignano announced at a House Ways and Means Committee hearing that the IRS is changing its position on the refundable credit:

I am pleased to announce that for tax year 2025, carry-forward amounts of the adoption credit for prior years are refundable up to $5,000 per qualifying child, and the IRS is implementing this policy as expeditiously as possible without disrupting the current filing season. The IRS will publish additional information on this very soon. Taxpayers should continue to claim the credit as directed by the current forms and instructions during tax season, since the IRS is pursuing post-filing remedies to resolve this issue.

Based on the testimony, it appears the IRS may automatically adjust returns and issue refunds later this year, similar to what it did for the 2020 unemployment exclusion. However, one major complication is that the refundable amount is $5,000 per child, and carry forward credits are not allocated to a specific child on Form 8839.

The current version of Form 8839 lacks sufficient information to apply the forthcoming per-child calculation. In addition, there was no method in prior tax years to allocate unused credit amounts to a specific child, as it was unnecessary. The IRS’s forthcoming guidance must resolve these issues, and it will likely be messy, and the IRS’s potential automatic adjustments may be incorrect for some taxpayers.

Taxpayers with an adoption credit carry-forward from 2024 may want to delay filing their 2025 Form 1040 for a few weeks to see if future guidance is released.

Example

William has a $11,252 adoption credit carry-forward from tax year 2024, and has a tax liability limitation of $3,222. Using the current Form 8839 calculation method, his allowed 2025 credit is $3,222, and he would carry a $8,030 credit to tax year 2026.

Under the revised calculation method, if the $11,252 is attributable to one child, William would receive a $5,000 refundable credit and a $3,222 nonrefundable credit, for a total credit of $8,222, and he would carry a $3,030 credit to tax year 2026.

However, if the $11,252 is attributable to two children and the carry-forward is allocated pro rata, William would receive a $10,000 refundable credit ($5,000 for each child) and a $1,222 nonrefundable credit, for a total credit of $11,222.

Acknowledgements

Thank you to Ryan Reichert, EA, CFP(r), co-owner of Brass Tax Presentations, who heard about the issue and called me to discuss it.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

Most of the actions below can significantly affect a taxpayer’s compliance profile and tax liability and should not be undertaken without a thoughtful, paid tax planning analysis. If that has not been done and there is insufficient time to do so, most of these actions can be made prospectively to take effect mid-year, to take advantage of the benefits for a portion of tax year 2026.

Filing an Extension. Filing an extension not only avoids late-filing penalties but also preserves the right to file a superseding return (covered in this prior article) by the unextended due date of the tax return. Entities that plan to file timely should still consider filing an extension to preserve the right to file a superseding return.

Undoing a Prior Entity Election. An LLC can withdraw a prior election to be treated as a corporation before the unextended due date of the first entity return. This is ideal for unwanted S corporation elections; this is done by filing a withdrawal statement with the IRS Service Center. If the corporation election is withdrawn, the S corporation election is automatically terminated. See Internal Revenue Manual 3.13.2.27.10 (01-01-2024), Request to Withdraw Classification Election, for additional information.

LLC or Corporation Election to be Taxed as an S Corporation. The entity should file Form 2553, Election by a Small Business Corporation, by March 16, 2026, to make an S corporation election effective on January 1, 2026. For the LLC, no Form 8832, Entity Classification Election, is required; an entity is deemed to make the corporation election by filing Form 2553. See §1362(b)(1)(B) and Treas. Reg. §301.7701-3(c)(1)(v)(C).

LLC Election to be Taxed as a C Corporation. An LLC should file Form 8832 by March 17, 2026, for a C corporation election to be effective on January 1, 2026. The corporation election cannot be filed more than 75 days after the effective date; the timing differs from that for an S corporation election. See Treas. Reg. §301.7701-3(c)(1)(iii).

LLC Election to Revert to a Disregarded Entity or Partnership. An LLC should file Form 8832 by March 17, 2026, for the reversion to be effective on January 1, 2026. This is for LLCs treated as both C corporations and S corporations; no separate S corporation election revocation is required. See Treas. Reg. §301.7701-3(c)(1)(iii) and Internal Revenue Manual 3.13.2.23.17(4) (03-08-2023), Termination of S-Election.

Important reminder: if the initial entity classification election was not effective on the LLC’s formation date, the LLC must wait 60 months to elect to revert to its default classification unless there was a significant ownership change. See Treas. Reg. See Treas. Reg. §301.7701-3(c)(1)(iv) for additional information.

LLC or Corporation Revocation of an S Corporation Election. The entity should file a S corporation election revocation statement with the Service Center by March 16, 2026 to be effective on January 1, 2026. The effective date should be stated; if the IRS receives it after March 16, 2026, the revocation will be effective on January 1, 2027. After the revocation, the entity will be taxed as a C corporation. There is no IRS form for this action; the revocation statement must have all the elements outlined in the relevant Internal Revenue Manual provision. See §1362(d)(1)(C)(i) and Internal Revenue Manual 3.13.2.23.15(1) (03-08-2023) for additional information.

Examples. This prior article has several examples of the actions described above.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

Non-Employee Qualified Tips Deduction Limit

§224(c) limits the qualified tips deduction for a non-employee to the extent that the gross income of the business exceeds the deductions allocable to that business.

The IRS previously interpreted that provision to mean that the net Schedule C income was the limit on the tips deduction; this is a pro-taxpayer interpretation. The 2025 Form 1040 instructions, revised on January 30, 2026, state the following on page 104:

Qualified tips from a trade or business can’t be more than the gross income from the trade or business in which the qualified tips were received minus the total of all deductions (other than the deduction for qualified tips) allocable to that trade or business. This limitation applies to each trade or business separately. For example, in the case of a sole proprietor who reports all deductions allocable to the trade or business in which qualified tips were received on a Schedule C, the net income limitation will be the net profit shown on the Schedule C for that trade or business… [emphasis added]

The 2025 Form 1040 instructions, revised on February 25, 2026, now completely change their original position and state the following on page 104:

Qualified tips from a trade or business can’t be more than the gross income from the trade or business in which the qualified tips were received minus the total of all deductions allocable to that trade or business, including the deductible part of self-employment tax; the deduction for contributions to self-employed SEP, SIMPLE, and qualified plans; and the self-employed health insurance deduction, but not including the deduction for qualified tips. [emphasis added]

The new instruction is more consistent with the statute and the restatement in the proposed regulations. This approach is also consistent with the qualified business income (QBI) calculation for the §199A deduction under Treas. Reg. §1.199A-3(b)(1)(vi), which mentions that the same three deductions reduce QBI.

Example

Sarah is a self-employed rideshare driver, and her net Schedule C income is $18,225; assume that her total earned income is under the Social Security wage base. The net income limitation for the §224 qualified tips deduction was $18,225 under the old instruction, and it is now $16,937 ($18,225 less $1,288, which is 50% of the $2,575 in self-employment tax) under the new instruction.

Fixing the Issue

Taxpayers who relied on the prior instruction may consider filing a superseding return to adjust the amount of their qualified tips deduction.

Acknowledgements

Thank you to Ryan Reichert, EA, CFP(r), who identified the issue and called me, and Josh Youngblood, EA, CRETS, who found the old version on the dark web (it is no longer available on the IRS website).

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

Read more

A taxpayer’s right to file a superseding return is rooted in long-standing Supreme Court precedent. In Chief Counsel Advice 202026002, the IRS said that Haggar Co. v. Helvering, 308 U.S. 389 (1940) has “come to stand for the proposition that a superseding return, whether filed on extension or not, is effective for most purposes.”

As the March 15 and April 15 deadlines for tax year 2025 quickly approach, it is critical to understand why and how a taxpayer should consider filing a superseding return.

What is a Superseding Return?

Internal Revenue Manual 21.6.7.4.10(2) (10-01-2025) states:

An amended (Form 1040-X) or corrected (duplicate) return filed on or before the due date or the extended due date is a superseding return…

The Taxpayer Advocate explains how a superseding return is different from an amended return:

Generally, superseding returns are intended to replace or supersede (hence the name) a timely filed original return with a subsequent timely filed return… The changes made by a superseding return are, in effect, incorporated into and relate back to the original return…

In contrast, an amended return changes items reported on an original return but is filed after the original filing deadline, including extensions… The filing of an amended return modifies the original filed return, and the IRS treats it as the taxpayer’s return of record.

The IRS is not legally required to process an amended return. As the Supreme Court stated in Badaracco v. Comm., 464 U.S. 386 (1984):

…the Internal Revenue Code does not explicitly provide either for a taxpayer's filing, or for the Commissioner's acceptance, of an amended return; instead, an amended return is a creature of administrative origin and grace.

Reasons to File a Superseding Return

The primary reason to file a superseding return rather than an amended return is to change an irrevocable election; certain elections made on an original return cannot be changed on an amended return. Two common examples include:

1. A joint return election under §6013, and

2. An election to credit a refund to the following year’s estimated tax payments under Treas. Reg. §301.6402-3.

Important note: Internal Revenue Manual 21.6.7.4.10(4) (10-01-2025) states that a taxpayer filing a superseding return to change an irrevocable election must file it before the unextended due date.

Therefore, a taxpayer who timely filed a married filing jointly tax return can file a superseding return before the unextended Form 1040 deadline and change to a married filing separately tax return, which negates joint and several liability.

Another reason to file a superseding return versus an amended return is to reduce the §6694 or §6695 estimated tax penalties if the superseding return shows a lower total tax. For example, under Rev. Rul. 83-36, if an individual taxpayer files a superseding return, the revised tax amount is used to determine whether the total prepayments meet the 90% of current-year tax prong. If the taxpayer files an amended return, the tax shown on the original return is used to calculate the 90% prong.

Partnerships that cannot opt out of the centralized partnership audit regime (CPAR) can file a superseding return by the extended due date (if an extension was filed) and avoid the administrative adjustment request (AAR) process.

A superseding return can generally be used to correct erroneous tax items in the same way as an amended return; however, there may be no material benefit to the superseding return other than providing the correct information as soon as possible to the IRS, potentially avoiding future IRS inquiries.

How to File a Superseding Return

To electronically file a superseding return, whether it is Form 1040 for individuals, Form 1065 for partnerships, or Form 1120 for corporations, the entire return should be prepared and electronically transmitted with the “superseding return” box checked in the software; there is no box on the actual form to indicate a superseding return. The IRS has a website that explains this for corporate returns.

If the return must be mailed to the IRS, write “SUPERSEDING RETURN - IRM 21.6.7.4.10” at the top of the first page to facilitate proper processing. The statement is not a formal procedural requirement, but could avoid it being flagged as a duplicate return. In addition, be sure the IRS receives the return before the applicable due date.

It is a best practice to file automatic extensions for partnership and corporate tax returns, even if not needed, to preserve the right to file a superseding return.

The decision for Form 1040 extensions is more complicated because Treas. Reg. §1.6081-4(b)(4) requires a proper estimate of the tax liability for the extension to be valid, which requires significantly more effort. In addition, a Form 1040 extension extends by six months one of the time periods that must run for a tax to be discharged in a bankruptcy proceeding; an unnecessary extension could cause certain tax debts not to be discharged. My prior article on best practices for Form 1040 extensions contains a lot more information on these issues.

Assessment Statute of Limitations Effects (For Paid Subscribers Only)

Read more

The §45B credit initially applied only to businesses that provide, deliver, or serve food or beverages for consumption if tipping is customary (i.e., restaurants). For these businesses, tips used to meet the federal minimum wage rate in effect on January 1, 2007 ($5.15 an hour) are not eligible for the credit.

For tax years beginning after December 31, 2024, the §45B credit also applies to certain beauty services businesses if tipping is customary. For these businesses, tips used to meet the current federal minimum wage rate ($7.25 an hour) are not eligible for the credit. Beauty services that qualify for the §45B credit include barbering and hair care, nail care, esthetics, and body and spa treatments.

Calculating the Credit

The business calculates the §45B FICA tip credit on Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips.

Step 1: Identify the tips on which the business paid FICA tax. (Line 1)

These are the tips that the employee reported on which the business paid employer Social Security and Medicare taxes during the tax year. Service charges determined by the business and not voluntarily made by the customer are not tips; see Rev. Rul. 2012-18.

Step 2: Calculate any tips that are not creditable. (Line 2)

If the employee’s wages (excluding tips) are less than $5.15 per hour (restaurants) or $7.25 per hour (beauty services), some of the tips are not creditable. The noncreditable portion equals the amount that would be payable to the employee at $5.15 per hour (restaurants) or $7.25 per hour (beauty services) minus the actual wages (excluding tips) paid to the employee.

Step 3: Determine creditable tips. (Line 3)

Subtract any non-creditable tips from the total tips to determine the credit base.

Step 4: Figure the credit amount. (Line 4)

Multiply the creditable tips by the 7.65% FICA tax rate to compute the credit amount.

Claiming the Credit

Under §45B(c), the business claiming the §45B credit must reduce its payroll tax expense deduction by the credit amount.

For partnerships and S corporations, the credit is a separately stated item reported on the owner’s Schedule K-1 and claimed by the owner(s) on their tax returns.

The §45B credit is a component of the §38 general business credit, and unused credits can be carried back one year or carried forward for up to 20 years under §39.

If a taxpayer who qualified for the §45B credit omitted it, the taxpayer can file an amended return to claim the credit, subject to the refund statute of limitations.

Restaurant Calculation Example

A food or beverage employee worked 100 hours and received $450 in tips for January 2026. The worker received $375 in wages (excluding tips) at the rate of $3.75 an hour. If the employee had been paid $5.15 an hour, the employee would have received wages, excluding tips, of $515. For §45B credit purposes, the $450 in tips is reduced by $140 (the difference between $515 and $375), and only $310 of the employee’s tips for January 2026 is taken into account in calculating the credit.

The credit amount for this employee is $24, which is 7.65% of $310. The employer must also reduce its payroll tax expense deduction by $24.

Beauty Services Calculation Example

A beauty services employee worked 100 hours and received $450 in tips for January 2026. The worker received $725 in wages (excluding tips) at the rate of $7.25 an hour (the current federal minimum wage). Since the employee was paid at least $7.25 per hour, the entire $450 tip amount is eligible for the §45B credit.

The credit amount for this employee is $34, which is 7.65% of $450. The employer must also reduce its payroll tax expense deduction by $34.

IRS Webpage is Wrong

The IRS has a webpage that provides an overview of the §45B FICA tip credit; however, the current version, last updated in August 2025, incorrectly applies the $7.25 wage threshold to restaurants, which is inconsistent with §45B(b)(1)(B) and the 2025 Form 8846 instructions. It also omits the addition of beauty services businesses.

This significant error reinforces that content on the IRS website is not appropriate for taking positions on tax returns. Tax professionals should rely on the authorities listed in Treas. Reg. §1.6662-4(d)(3)(iii) (e.g., the Code, Treasury regulations, court cases, etc.). Please note that IRS publications are not included in this list of authorities and should not be relied upon for tax return positions.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

In Notice 2025-69, the IRS gave guidance on how employees can determine their overtime deduction for tax year 2025; however, it was silent on complex issues.

For tax year 2025, it is best practice for employees to provide their last pay statement with their Form W-2 to facilitate the determination of any potential overtime deduction.

What overtime pay is eligible for the deduction?

Overtime compensation is eligible for the deduction only if it is paid under §7 of the Fair Labor Standards Act (FLSA), which is 29 U.S.C. §207. The employee must be covered and non-exempt under the FLSA to be eligible for the overtime deduction.

In addition, the deduction amount is only the premium portion, which is the amount exceeding the regular rate of pay (i.e., the “half” in “time-and-a-half). The deductible amount is called qualified overtime compensation. For example, if an employee earns $20 per hour and the FLSA-required overtime rate is $30 per hour, the deduction is $10 per hour for hours worked in excess of 40 in a week.

Key problem points with this definition:

• California and other states require overtime beyond the FLSA amounts; those overtime amounts are not eligible for the deduction.

• The Railway Labor Act and other federal laws exempt specific industries or employees from the FLSA, and overtime is paid based on negotiated contracts or other provisions. Overtime paid under these rules is not eligible for the deduction.

• Voluntary overtime paid in excess of the FLSA-required time-and-a-half, such as double time, is not eligible for the deduction.

  If you find value in Tom Talks Taxes, please become a free, paid, or Tax Toolbox subscriber.

Are employers required to report deduction amounts for tax year 2025?

There is no required reporting for tax year 2025. In Notice 2025-62, the IRS waived penalties for failing to report the qualified overtime compensation amount on Form W-2; however, employers were “encouraged” by the IRS to provide the information to employees in a separate statement or in box 14 of Form W-2.

Starting in 2026, qualified overtime compensation will be reported on Form W-2, box 12, using code TT (according to the current draft).

What if box 14 on Form W-2 does not state the deduction amount?

Under Notice 2025-69, the taxpayer can use their own records, such as their pay statements, to determine the qualified overtime compensation amount. Not having a box 14 entry on a Form W-2 does not mean the employee does not qualify for the overtime deduction.

These two methods come from Notice 2025-69:

• If the FLSA-eligible worker is paid 1.5 times their regular rate only for hours worked in excess of 40 per week, the deduction amount is 1/3 of the total overtime pay for the year, as detailed on the year-end final pay statement.

• If the FLSA-eligible worker is paid twice their regular rate only for hours worked in excess of 40 per week, the deduction is 1/4 of the total overtime pay for the year, as detailed on the year-end final pay statement.

If a taxpayer has a mix of eligible and ineligible overtime amounts, and the final pay statement does not separate those amounts, the tax professional may need to use a reasonable estimate to allocate the overtime. For example, if the taxpayer states that most of their overtime is from working more than 40 hours per week, but some is from working more than 8 hours per day, an 80% allocation of the total overtime amount may be reasonable. In this case, the deductible qualified overtime compensation is 80% of the total overtime pay multiplied by 1/3, assuming all overtime pay was paid at 1.5 times the regular rate.

If the box 14 amount is inconsistent with the total overtime amount (e.g., the box 14 amount is 100% of the total overtime reported on the last pay statement), due diligence requires practitioners to investigate inconsistent documents and ask questions to determine the correct qualified overtime compensation amount.

Materiality is important to consider as well. Does it make sense to spend significant time investigating a discrepancy or issue for a $100 change in total tax?

What are the limitations on the deduction?

The maximum deduction is $12,500 (or $25,000 married filing jointly). A taxpayer filing married filing separately is ineligible. There is no limit on the amount one spouse can contribute to the deduction. The overall limitation is applied before the income limitation below.

The deduction phases out starting at $150,000 (or $300,000 married filing jointly) of modified adjusted gross income (MAGI). MAGI is AGI plus the §911, §931, and §933 exclusion amounts.

For every $1,000 the taxpayer exceeds the threshold, their deduction is reduced by $100; fractional amounts do not reduce the deduction.

For example:

• If a single taxpayer has $12,500 of qualified overtime compensation, their deduction fully phases out at $275,000 of MAGI.

• If a married filing joint taxpayer has $25,000 of qualified overtime compensation, their deduction fully phases out at $550,000 of MAGI.

If the taxpayer’s deduction amount is $0 due to their income, there is no reason to spend any time determining their qualified overtime compensation amount.

Join the Conversation

If you are a paid subscriber, you can talk about this topic in the comments section. Please keep the discussion related to this edition’s topic.

Leave a comment

Read more