Inequities of tip income deduction + tip for contractors providing services to non-business customers

The OBBBA (P.L. 119-21; 7/4/25) adds a new deduction of up to $25,000 for qualified tip income. I blogged on this idea before the text of the OBBBA proposal existed, noting several oddities of the deduction (2/23/25 post). Less than 3% of employees earn tip income (the Budget Lab at Yale estimates it is about 2.5% of employees and I cannot find an estimate of the number of contractors who get tips, but it likely is a higher percentage, but still a minority of contractors).

Why should these workers get a tax break that others with similar income levels don't get? Assume two employees each have wage income of $60,000 but for one worker, that figure incudes $10,000 of tip income. That employee will only have to include $50,000 in their taxable income and the non-tipped employee must include the entire $60,000 in their taxable income.  It might even be that the non-tipped employee worked more hours than the other employee. What is the rationale for this? Why not increase the standard deduction or the EITC or add a new bracket below the 10% bracket? Note that both of these employees do pay employment taxes on the same amount of earned income - $60,000.

Unlike some other tip tax break proposals, the OBBBA tip income deduction also applies to contractors with qualified tips. But an oddity in the law creates inequities for contractors because a qualification for a tip deduction is, per IRC §224, that the tip income be "included on statements furnished to the individual pursuant to section 6041(d)(3), 6041A(e)(3), 6050W(f)(2) or 6051(a)(18) or reported by the taxpayer [employee] on Form 4137 (or successor)."

OBBBA amends the above reporting rules to require the issuer to note any tip amount. For example, §6050W on issuance of Form 1099-K was amended to require issuers to make a separate reporting of the portion of reportable payments that "have been reasonably designated by payors as cash tips and the occupation" of the recipient. Thus, Congress only allows contractors to get a tip income deduction (assuming all other requirements are met) if they are reported on a 1099-NEC, 1099-MISC or 1099-K.

Contractors who provide services to non-businesses, such as to households, do not get a 1099-NEC. For example, consider two gardeners each earning $70,000 including tips, who accept payment only by cash or check. The one gardener provides services to businesses each of which receives $600 or more in services in 2025 ($2,000 in later years), so will get Forms 1099-NEC on which the payors will be required to show the cash tip amount. In contrast, the gardener providing the same value of services to households with the same portion of tip income, will not have any Forms 1099-NEC so will not be able to claim a tip income deduction.

This is illustrated on draft Schedule 1-A, Part II, which only has lines for reporting tip income reported on the forms noted above.

But, there is a possible solution for contractors who provide tipped services to non-business clients. Have clients pay by credit or debit card, or use a third party settlement organization such as PayPal or Venmo and be sure you have over 200 payments totaling over $20,000 for the year to be sure the TPSO has to issue you a 1099-K.  Guidance is not yet out, but I assume when it is, the TPSOs will ask payors how much, if any, of the amount transferred to someone for services is tip income and the occupation of the service provider. I assume that debit and credit card processors will have to start separately reporting the tip amount from charge receipts.

Was the required reporting on W-2, 1099-NEC, 1099-MISC or 1099-K purposeful by Congress to better ensure proper reporting of the tip income amount and the ability for the taxpayer, tax preparer and IRS to verify it? Perhaps, but it seems a bit harsh for contractors serving non-business clients when they are already required to keep proper records under §6001 and regulations.

AND, don't forget that §224 has a restriction that a worker receiving tips in a business that is a specified service trade or business (SSTB) under §199A(d)(2) cannot claim the tip income deduction.  An SSTB is a business in the field of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, or which involves performance of services that consist of investing and investment management, trading, or dealing in securities (§475(c)(2)), partnership interests, or commodities.

This is also an oddity and unfair.  For example, a dancer, singer or magician employed by a casino or restaurant is eligible for the tip income deduction (assuming all requirements are met) because restaurants and casinos are not SSTBs. However, a dancer, singer or magician working for a company that provider entertainers for parties or is a theater company, appears to be an SSTB making these employees ineligible for the tip income deduction (see Reg. 1.199A-5 for more on SSTB). Seems unfair since regardless of the employer, they are in a tipped profession.  Overall, the tax law would be more equitable to remove SSTB from §199A where it also creates inequities for some businesses that are SSTBs.

The tip income deduction will only be around for four years, unless extended. Hopefully the roughly 90% of workers who don't get this tax break even though they have earned income equal to or less than tipped workers, will seek its repeal with any income tax break instead tied to providing it to low to middle income workers based on income rather than occupation and who they work for.

What do you think?

Another Change for Filing Form 1099-K

The American Rescue Plan Act of 2021 (P.L. 117-2, 3/11/21) lowered the filing threshold for Form 1099-K by third-party settlement organizations (TPSO). Since first enacted in 2008, IRC §6050W had a de minimis exception for third-party settlement organizations (such as PayPal) where they only had to issue a 1099-K to the IRS and customer if they processed over $20,000 of payments AND over 200 transactions for the customer for the year. Starting for 2022, ARPA lowered this to only except filing 1099-K if payments processed were $600 or less. But it also specified that the filing was only if the payments were processed for the sale of goods or services.

Since that change, there were concerns raised about lots more Forms1099-K to be received for 2022. But, I argue that is a good result because data has shown for decades that income tax reporting is better when the taxpayer receives an information return (such as a W-2 for wages), and better yet if there is withholding (no withholding for 1099-K unless backup withholding applies). But, some of the 1099-Ks would also be for selling household/personal use items at a loss. That loss is not allowed, so what does one do with the 1099-K to prevent IRS from sending a CP-2000 notice saying the recipient owes more taxes?  I think this is the reason there was a high filing thresholds from the start of IRC §6050W for third party settlement organizations. The main reporting under §6050W is for the gross amount of credit and debit cards processed and such cards generally are only accepted by merchants.

On December 23, 2022, the IRS issued IR-2022-226 and Notice 2023-10 announcing they are delaying the effective date of the ARPA change for TPSOs. They are now calling 2022 a transition year and per Notice 2023-10, "a TPSO is not required to report payments in settlement of third party network transactions with respect to a participating payee unless the gross amount of aggregate payments to be reported exceeds $20,000 and the number of such transactions with that participating payee exceeds 200." So they are going back to the old de minimis rule for TPSOs for 2022.

On December 28, 2022, the IRS issued new FAQs on dealing with 1099-Ks that are either issued for personal use transactions producing a loss or issued incorrectly (not for sale of goods or services). I suspect they did this because some TPSOs might still issue the 1099-Ks per the ARPA change. After all, they should have been updating their IT systems long before December 23 as the 1099-Ks are generally due by January 31. I suspect though that for public relations purposes, while the IT systems will likely still produce the reports, the TPSOs will not issue the smaller ones to the taxpayers or the IRS - extra work for them.

Observations:

1. Where does the IRS get the authority to change the statutory effective date for the §6050W change, that is spelled out in P.L. 117-2 (Sec. 9674)? This is not the first time such a change has been made, there were a some Affordable Care Act changes where IRS changed the effective date. But if done for effective tax administration, perhaps Congress should just give IRS/Treasury blanket authority to do so within specified parameters and with the caveat that Congress can override that within 30 days.  

2. The FAQs released on 12/28 provide a remedy for dealing with a 1099-K received for a non-taxable activity. If people are just sending gifts or splitting restaurant bills using TPSOs, there should be no 1099-K, but mistakes can be made (including by the sender of funds saying the funds ARE for sale of goods or services even when they were not). And some sales of goods such as selling unwanted household items and clothes, produce a non-taxable loss. Here is what the FAQs say to do with such a 1099-K:

The example is sale of your old refrigerator for $600 (better example would be sale for $601). You originally paid $1,000 for it. Report the 1099-K amount on Schedule 1, line 8z and write on that line: "Form 1099-K Personal Item Sold at a Loss". Then on line 24z, write the same and also enter $600 (1099-K amount). This enables the IRS to see that the 1099-K was addressed. Of course, if you sold multiple items including some at a gain, this gets more complicated.

Earlier this year, I suggested that the IRS create a new form or schedule for reconciling incorrect information returns to avoid unnecessary issuance of CP 2000 notices and provide greater certainly to taxpayers and practitioners that they were properly filing the return. I had the opportunity through the DC Delegation project of the California Lawyers Association Tax Section to present this proposal to staff of congressional tax committees, IRS Chief Counsel Office, the National Taxpayer Advocate and more. I also have it written up in this June 20, 2022 Tax Notes State article. I think this is something worth pursing as there are various information returns that require reconciliation but no place to easily do that.

3. If a business owner uses a TPSO account, such as PayPal for both personal and business transactions, get this fixed this coming year to have separate accounts for personal and business to lessen reporting issues.

What do you think?