The One Big Beautiful Bill Act President Donald Trump signed last July was supposed to fulfill a simple pledge he had made on the campaign trail: “no (federal) tax on tips.” To do that, Congress created a new, temporary income tax deduction (in force for 2025 through 2028) for qualified tips under section 224 of the U.S. Tax Code.

The deduction was limited and complicated from the start. Now, incredibly, a full month after the start of the filing season for 2025 returns, the IRS has revised the Form 1040 instructions in a way that effectively changes how the deduction is calculated for self-employed workers. That revision is likely to limit the benefit of the deduction for some self-employed tipped workers and could create problems for some taxpayers who have already filed based on the old instructions. (The IRS has not responded to a request for comment on the change or its impact.)

To see why the rules are so complicated and what has changed, it helps to start with the basics.

The Basic Mechanics of the Tips Deduction

Under the new law, you can deduct qualified tips received during the year if the tips come from an occupation that usually receives tips. The deduction applies to both traditional employees, such as restaurant servers, and to self-employed workers who receive tips in connection with a trade or business, including rideshare drivers or delivery workers.

The deduction is limited to $25,000 per year. It also gradually phases out once a taxpayer’s modified adjusted gross income exceeds $150,000 for single filers or $300,000 for married taxpayers filing jointly. In practice, this means the deduction primarily targets low- and middle-income workers in tipped occupations.

For employees, the rules are fairly straightforward. If the tips qualify and the taxpayer’s income is below the phaseout threshold, the deduction generally applies to the amount of tips received, up to the $25,000 cap.

Things become more confusing when tips are earned through a trade or business, including by gig workers. In that case, there’s an additional limit under section 224(c). The deduction cannot exceed the gross income from the business, less the deductions allocable to that business.

That bit—“deductions allocable to the trade or business”—is the main source of most of the confusion.

How the IRS Originally Interpreted the Limit

The IRS began rolling out guidance in the summer of 2025, starting with a brief fact sheet. That was followed in September with a draft of Schedule 1-A, which appeared to limit the deduction to “the net profit from the trade or business.” Even though the deduction was capped at $25,000, under that approach, if the business earned $10,000 in profit, the tip deduction was limited to $10,000.

This meant that several self-employment income-related deductions were effectively ignored when calculating the cap. These included deductions for one-half of self-employment tax, self-employed health insurance, and contributions to SEP or SIMPLE retirement plans. Since those deductions appear on Schedule 1 rather than Schedule C, they were not assumed to be considered as part of the deduction limit. This was pretty taxpayer-friendly, since it allowed the deduction to be calculated using the business’s net profit without further adjustments.

In November, the IRS issued Notice 2025-69, which generally outlined the deduction (and announced some transitional reporting relief) but opted out of a deep dive into the provision, noting in the examples section that they “do not address other limitations on the deduction allowed under section 224(a), including the overall limit on deductions in section 224(b)(1), the MAGI limit in section 224(b)(2), and the social security number requirement in section 224(e).”

The proposed regulations, which were also issued in November 2025, simply noted that the regulations “would restate the statutory limit, which is the difference between the gross income from the taxpayer’s trade or business for the taxable year minus the sum of deductions (other than the deduction for qualified tips) for that trade or business for the taxable year.” The examples in the proposed regulations refer to net income and do not specifically call out those Schedule 1 deductions (for one-half of self-employment tax, self-employed health insurance, and contributions to SEP or SIMPLE retirement plans).

The IRS Changes Its Position

A January 30, 2026, edition of the Form 1040 instructions continued to use that “net income” language without any reference to deductions outside of Schedule C. But on February 25, 2026—about a month after the tax season began—the IRS updated the Form 1040 instructions. The revised instructions use the same “net income” language but make clear that the tips deduction is further limited by subtracting all deductions allocable to the trade or business, including several deductions that appear outside Schedule C. The instructions specifically mention the deductible portion of self-employment tax, the self-employed health insurance deduction, and contributions to self-employed retirement plans—largely those Schedule 1 deductions. As a result, the deduction limit is now calculated by starting with gross business income and subtracting both Schedule C expenses and these additional self-employment-related deductions.

To be fair, the IRS’s revised interpretation appears to be more closely aligned with the statutory language. The phrase “deductions allocable to the trade or business” is broad, and similar deductions are categorized as business-related elsewhere in the tax code. For example, the regulations under section 199A for the qualified business income deduction consider the same three deductions—half of self-employment tax, self-employed health insurance, and retirement contributions—as reductions to business income.

Nonetheless, this will likely catch many taxpayers (and tax pros) off guard, especially given the timing. The revision was included in updated instructions issued during the filing season, rather than in a formal notice or regulation.

What Happens in a Loss Year

Because the deduction is limited to the business’ gross income minus its deductions, the calculation can produce a negative number if the business operates at a loss. When that happens, the tips deduction effectively disappears.

This issue is most likely to affect gig economy workers. Rideshare and delivery drivers often report significant vehicle expenses that reduce or eliminate their Schedule C profit. When those expenses push the activity into a loss, the statutory limitation prevents the taxpayer from claiming any tips deduction.

That feels logical when you look at the math. But it can mean a taxpayer may have received tips and included them in income, but not be able to claim the deduction because the overall activity produced a loss. That makes the “no tax on tips” moniker even more confusing.

Multiple Businesses Make Things Even Messier

There’s an additional complication for taxpayers who operate more than one business. If a taxpayer earns tips from one business but also has income from another, the tips deduction cannot exceed the profit from the specific activity that earned the tips. Income from other businesses does not increase the allowable deduction.

Here’s where it gets tricky. Deductions may need to be divided among multiple activities. For example, the deductions for half of the self-employment tax, the self-employed health insurance deduction, and retirement contributions are all based on total self-employment income, not on a per-business basis. When a taxpayer has multiple businesses, the challenge is deciding how to allocate those deductions among them to determine the section 224 limitation. The statute does not offer a clear way to do this, and current guidance offers little direction. As a result, different allocation methods may result in different deduction limits.

How This Might End Up in Tax Court

The lack of clear direction—and late timing—could lead to controversy. If a dispute over section 224 eventually reaches the Tax Court, it will likely follow the same path most income tax controversies do: a disagreement on audit.

In this case, it’s likely to result from a finding that a taxpayer overstated the qualified tips deduction. For instance, the IRS might decide that the taxpayer didn't reduce the limitation by deductions such as the self-employment tax deduction or the self-employed health insurance deduction under the revised interpretation in the Form 1040 instructions. If the IRS adjusts the deduction during an audit, the agency would issue a notice of deficiency reflecting the additional tax owed. At that point, the taxpayer could petition the Tax Court.

A dispute could also result from how a taxpayer allocates deductions across multiple businesses. Since section 224 applies the limitation separately to each trade or business, taxpayers might use different methods to allocate deductions, such as divvying up the self-employment tax deduction among activities. If the IRS challenges the allocation method during an audit, the resulting deficiency could also be litigated in Tax Court.

Some taxpayers may have filed early returns before the most recent instructions. If those returns are later examined and the IRS applies the revised interpretation, the adjustment could result in a deficiency dispute that ultimately reaches the Tax Court.

What this means is that section 224 cases are unlikely to involve sweeping challenges to the statute itself. More likely, they will arise in deficiency cases in which the IRS and the taxpayer simply disagree about how the deduction limit should be calculated.

The section 224 tips deduction was introduced as a straightforward policy to lower the tax burden on tipped workers. In practice, the provision is much more complicated.

The IRS has already revised its interpretation of the deduction limitation once during the filing season, and practitioners are still navigating how the rules apply in loss years and in cases involving multiple trades or businesses. Taxpayers who relied on earlier guidance (or lack thereof) may need to file a superseding return (or amended return, depending on timing).

As more returns are filed and more fact patterns—especially involving gig-economy workers—emerge, additional guidance and possibly litigation may play a role in how section 224 ultimately operates.

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