Prop. regs. issued on new qualified tips deduction

Editor: Susan M. Grais, CPA, J.D., LL.M.

Treasury and the IRS in September released proposed regulations (REG–110032–25) with guidance on the new federal income tax deduction for tips, which was enacted in H.R. 1, P.L. 119–21, known as the One Big Beautiful Bill Act (OBBBA), for tax years 2025 through 2028. The proposed regulations define “qualified tips” for purposes of the deduction and list the qualifying occupations.

Once finalized, the regulations will apply to tax years beginning after Dec. 31, 2024. Taxpayers may rely on the proposed regulations for tax years beginning after Dec. 31, 2024, and on or before the date final regulations are published, as long as they follow them in their entirety and in a consistent manner.

Background

The OBBBA created Sec. 224, which allows a federal income tax deduction for qualified tips of up to $25,000 for employees and independent contractors. The deduction is available to itemizers and nonitemizers and begins to phase out for adjusted gross income over $150,000 ($300,000 in the case of a joint return). The act also specified that tips do not qualify for the deduction if they are received by an employee or owner in the course of a specified service trade or business (SSTB) (as defined in Sec. 199A(d)(2)), including performing services in the fields of health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; investing; investment management; trading or dealing in securities, partnerships interests, or commodities; or any trade or business whose principal asset is the reputation or skill of one or more of its employees or owners.

Qualified tips are defined as any cash tip received by an individual in an occupation that customarily and regularly received tips on or before Dec. 31, 2024, as provided by Treasury (Sec. 224(d)(1)). While the OBBBA did not include this list, Treasury was directed to publish a list of these occupations within 90 days of the OBBBA’s enactment on July 4, 2025. In September, Treasury released a preliminary list of the occupations that would qualify for the deduction under this provision.

Reporting requirements

Cash tips and the individual’s occupation must be reported on statements furnished to the taxpayer under Sec. 6041(d)(3), 6041A(e)(3), 6050W(f)(2), or 6051(a)(18), or reported by the taxpayer on Form 4137, Social Security and Medicare Tax on Unreported Tip Income (or its successor), for the tax year, beginning with calendar year 2025. The IRS announced that it will not update 2025 individual information returns/statements (e.g., Forms W–2, Wage and Tax Statement, or 1099 series) or withholding tables to reflect the deduction and associated reporting requirements, but transition relief will be provided for those claiming the deduction and those subject to the new reporting requirements. Rather, adjustments to the forms and withholding tables will be made beginning in calendar year 2026 (News Release IR–2025–82 and Fact Sheet FS–2025–03). The IRS subsequently released a draft Form W–2 for 2026 indicating that the qualified tip amount will be reported in box 12 using code TP and a required Treasury Tipped Occupation Code (TTOC) in new box 14b.

Definition of cash tips

The proposed regulations define cash tips for purposes of the deduction as tips that are:

• Received from customers or, in the case of an employee, through a mandatory or voluntary tip-sharing arrangement, such as a tip pool;
• Paid in a cash medium of exchange, including by cash, check, credit card, debit card, gift card, tangible or intangible tokens that are readily exchangeable for a fixed amount in cash (such as casino chips), and any other form of electronic settlement or mobile payment application that is denominated in cash;
• Not paid in any medium other than cash, such as event tickets, meals, services, or other assets that are not exchangeable for a fixed amount in cash (such as most digital assets); and
• Amounts that customers pay for services beyond what is required, charged, or reasonably expected in an arm’s-length transaction (Prop. Regs. Sec. 1.224-1(c)(2)).

Tips would meet the “voluntary” requirement only if there is no consequence if the tip is not paid, the tips are not subject to negotiation, and the payer determines the amount of the tip. Thus, service charges, automatic gratuities, and any other mandatory amounts automatically added to a customer’s bill by the vendor or establishment are not qualified tips, even if they are distributed to the employees. Tips would not be considered mandatory, however, if the customer is expressly given the option to disregard or modify the amounts added to the bill (Prop. Regs. Sec. 1.224–1(c)(3)). The proposed regulations give several examples of situations when amounts would be considered deductible.

The proposed regulations clarify the requirements concerning when amounts would be excluded from the definition of qualified tips because they are received by an individual in the course of an SSTB. Under the proposed regulations, the relevant business in making this determination would be the employer’s business. Therefore, if an employee received tips while working for an employer that is an SSTB, those tips would not be considered qualified tips — regardless of whether the employer or owner could claim a qualified business income deduction under Sec. 199A and/or the employee’s job is on the list of occupations that customarily and regularly received tips on or before Dec. 31, 2024. The proposed regulations give several examples.

In addition, the proposed regulations specify that employees who enter into a tipped employee participation agreement as part of the Tip Reporting Determination Agreement program or a model gaming employee tip reporting agreement as part of the Gaming Industry Tip Compliance Agreement program may determine the amount of qualified tips using the applicable tip rate in their agreement instead of reporting actual tips received (Prop. Regs. Sec. 1.224–1(c)(5)).

Qualified tips would not include amounts received: (1) for services that are a felony or misdemeanor under applicable law; (2) for prostitution services and pornographic activity; or (3) if the tip recipient has an ownership interest in or is employed by the tip payer (Prop. Regs. Secs. 1.224–1(c)(6)—(9)).

Married taxpayers would be required to include only the Social Security number (SSN) of the taxpayer who has received the qualified tips to claim the deduction. The SSN is required by both spouses only when both have qualified tips for which they are claiming a deduction (Prop. Regs. Sec. 1.224–1(e)).

Occupations that qualify for the tip deduction

The proposed regulations include a list of occupations that customarily and regularly received tips on or before Dec. 31, 2024, and therefore would qualify for the tip deduction. The list is the same as the preliminary list released in September. The list contains the TTOC, occupation title, a short description of the types of services performed by individuals working in an occupation included in this occupation code, and illustrative examples of specific occupations that would be included under the occupation code and the related Standard Occupational Classification system code of the U.S. Bureau of Labor Statistics.

Implications

Although Form W–2 or 1099 series forms will not be updated for tips received in 2025, some employers are expected to report qualified tips. The OBBBA provided a transition rule that allows furnishers to use any reasonable method provided by Treasury to approximate qualified tips received before Jan. 1, 2026 (OBBBA, §70201(k)). However, the IRS provided more generous relief in August, stating that for tax year 2025, “[e]mployers and payroll providers should continue using current procedures for reporting and withholding” (News Release IR–2025–82). The proposed regulations provide useful guidance to those employers on how to determine the amount of qualified tips to report. According to the proposed regulations’ preamble, the Council of Economic Advisers estimates that the qualified tips deduction will increase average take–home pay for tipped workers by $1,300 per year.

Some of the specific examples illustrating voluntariness of payment were provided in response to requests for clarification from the food and beverage industry and may provide comfort to employers seeking clarity on specific technologies, such as point–of–sale devices. According to data included in the preamble, approximately 45% of all reported tips go to bartenders and wait staff.

Rideshare drivers and companies may be pleased that the preamble specifically acknowledges the possibility that rideshare drivers “may operate as independent contractors rather than employees.”

Editor

Susan M. Grais, CPA, J.D., LL.M., is a managing director (retired) at Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with Ernst & Young LLP.