IRS Quietly Changes Tips Deduction Calculation Mid-Season
The change adds more confusion for non-employees claiming the tips deduction
Tax professionals already have a difficult tax season due to the One Big Beautiful Bill Act (OB3 Act) tax changes. It does not help when the IRS quietly drops a material change in the calculation of one of the significant new provisions during tax season in a revised IRS form instruction.
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).
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