The Tips Deduction Trap for Self-Employed Workers

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Welcome to Accounting in the Wild, where we'll discuss various subjects in the tax and accounting world. Also featuring tales from the field and interviews on various tax and accounting subjects. All this and much, much more on Accounting in the Wild. And now here's your host, Jason Dinason.

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Welcome to Accounting in the Wild. My name is Jason Dinason. This time around I wanted to talk about the tips deduction that was created in the one big beautiful bill, Schedule 1A deduction, and the self-employed sole proprietors can take a tips deduction as well. So it's not just the W-2 workers, the restaurant servers, and such. Self-employed people can take the tips deduction too if they get paid tips. However, there are nuances, and you might find that your self-employed clients actually can't take a tips deduction very often. We'll break it all down today. Now to understand the nuances with this, we have to understand Form 1099 K. And I get that that may seem random that I'm talking about we need to deal with the 1099 K. Just stay with me because I assure you it's not random. It actually has a place in our discussion of self-employed people and whether or not they can deduct tips. If we start with the 1099 K, we have to answer the question of do all issuers of the 1099 K report tips? Because one of the requirements under the law and the regulation under section 224, that all relates to the tip deduction, is that tips must be separately reported, separately stated on a reporting form. 1099K is one of those reporting forms. However, when you dig into this, you find that not every issuer of a 1099K is going to necessarily separately report tips because they don't have to. So there are two entities that issue a 1099 K. You have what are called PSEs, payment settlement entities, and then third party settlement organizations, TPSOs. And the issue is that only TPSOs are required to separately report tips. PSEs are not required to separately report tips. Before we go further, let's define what we're talking about here with this alphabet soup of TPSOs and PSEs. So TPSOs are places such as PayPal and Venmo, payment apps and platforms. There's a little more to it than that, of course, such as TPSOs also guarantee payment when a transaction is happening. But that definition of TPSOs being apps and platforms like PayPal and Venmo, that gives us enough of a basis to discuss what we're talking about today. And then you have payment settlement entities, PSEs, who are places that process card transactions like credit card and debit card transactions. So tips have to be separately stated on a reporting form in order for the recipient of tips to deduct those tips. The tips have to be separately stated on a reporting form. And this creates an oddity on the 1099K. And you really have to chase down an answer and fall deep into a rabbit hole in order to figure out the fact that only TPSOs are required to separately state tips. PSEs are not. And if you just read the code as updated in the big beautiful bill, it seems almost contradictory because there's one place that says third party settlement organizations separately report tips. And then there's another place that makes it sound like all issuers of the form separately report tips. And we don't get any help in section two twenty four or regulation one dot two twenty four-one, which is the new things relating to the tip deduction. So then we have to turn to committee notes from the House Ways and Means Committee. And on page sixty seven of those notes, we find a note that says regarding tip reporting, that it's third party settlement organizations must separately account for qualifying tips. And also in IRS notices 2025-62 and 2025-69, we're told the same thing. So that means you have these two issuers of the 1099K, third party settlement organizations and payment settlement entities, and only TPSOs have to separately report tips. That is a much bigger deal than it seems for self-employed people. Now let's talk about why that is. Tips have to be separately stated on a reporting form in order to be deducted by the recipient. And that creates a challenge for self-employed people who might not get a reporting form at all. And even if they do, if it's a 1099K and it's from a payment settlement entity, the tips aren't going to be separately stated. And if you don't have a reporting form that separately states the tips, you get no deduction. Let's look at some examples. So let's say we've got Joe the Barber, and he's self-employed, and he has a sign on his door saying, I don't accept credit cards cash only. So his customers usually leave him tips, it's all paid in cash. None of these customers are going to issue him a ten ninety nine. He has no reporting form at all for any of this. He can't take a tip deduction, even though his customers are paying tips to him, because he doesn't have anything on any reporting forms. Now let's look at an example of someone who receives a 1099K, but it's from a payment settlement entity. So Hattie the hairdresser runs a beauty salon. By the way, I'm pulling these examples from a session that I teach on this. So if Hattie the hairdresser runs a beauty salon and she accepts credit cards and debit cards as payment, and a lot of people pay her that way, and they leave tips charged to those cards. So if you're a business that accepts cards for payment, you have someone in the background handling that, probably a payment settlement entity. And payment settlement entities are required to issue a 1099K for any dollar amount. There's no transaction threshold, there's no dollar threshold, one transaction for one dollar would trigger a reporting form. But the law says payment settlement entities don't have to separately report tips. So let's say that Hattie takes in $60,000 from credit cards, $45,000 for her services and $15,000 of tips. She's going to get a $1099K at the end of the year showing $60,000 of receipts. But the tips will not be separately stated because this is a payment settlement entity. They don't have to separately report the tips. So here we have someone who's getting a $1099, and it is showing the tips rolled into the total gross receipts amount on the 1099. But she can't deduct the tips because the tips aren't separately stated on the 1099K. Now let's look at a third example: self-employed person getting paid through a third party settlement organization. Now here it seems like we might be getting warmer on being able to take a tip deduction because it's a third-party settlement organization and they have to separately report tips on the 1099K. But a lot of times those people are going to be out of luck also. So let's say we have Larry the landscaper, and Larry doesn't accept credit cards, but he does take payment via Venmo. And he has a business account set up at Venmo. 150 customers pay him that way. He takes in $75,000 from these customers, $60,000 for his services, $15,000 of tips. Venmo is a third party settlement organization. So Venmo has to separately state tips on a 1099K. However, Venmo isn't going to send a 1099K because they don't have to. Now, before you throw your hands up in the air or start cursing me out, or it's not my fault. I didn't write these 1099 K rules. Third party settlement organizations will only issue a 1099 K when the recipient's transaction count is above both 200 transactions and $20,000 received. Larry got $75,000, but from only $150 people, so he didn't cross the $200 transaction threshold. So Venmo won't send Larry a reporting form at all. And without that reporting form separately stating the tips, Larry can't take a deduction. Now let's finally look at an example where a self-employed person can take a tip deduction. So let's say that Larry, one of his customers, is a business customer that pays him $10,000 for his services and adds a $2,000 tip. So total payment is $12,000. And let's say they pay by check or ACH, and that Larry is not a corporation. He's just a sole proprietor. It's in his name. The business will send a $1099 NEC to Larry, and the NEC has been updated to include boxes for tips and the Treasury tip doccupation code, which would also have to be on the form. And so this payer would have to separately state the tip and show Larry's industry code. And as long as they do that, he can deduct the $2,000 of tips that he gets from this customer. Now hearing all of this, you may wonder if there are workarounds, because a lot of self-employed people are not going to get a 1099 at all if they're in a tipped industry. Or they accept credit cards, and if they have a payment settlement entity doing the processing, the payment settlement entity isn't required to separately report tips. So people come up with workarounds or attempts at workarounds. And here's the thing I'm going to be a dark cloud just like I have been the rest of this podcast, bringing doom and gloom at all of your attempts at getting around this whole no deduction if you don't have it separately stated on a form. Can you prove tips from the proprietor's point of sale system? No. It's very clear in regulation one dot two twenty four-one that separate reporting on a reporting form is required. That means W two ten ninety nines and self reported on the forty one thirty seven. Now let's talk about form forty one thirty seven. Can you self-report then on form forty one thirty seven? No, not if you're self-employed. That form is for W two employees. There's no mechanism on form forty one thirty seven for a self-employed person to use the form. Can you track separately in the QuickBooks file or other bookkeeping system? Well that's just like the point of sale system question. The answer is no. It has to be separate reporting on a 1099 or W two. What if you self report on Schedule C? Some practitioners have said under other income, what if I write in qualifying tips and report it there? That also doesn't work because it's very specific in the law and the regulation that it's W two, various types of ten ninety nines, or form forty one thirty seven. You should report the tips as income on Schedule C, but doing that doesn't allow you to take a deduction on Schedule one A for those tips. I think that the dark storm clouds that I brought to this podcast have passed, so we can close on a happier note, and that is with all of this 1099 K stuff and separate reporting forms and so forth, does that affect employees? And the answer is no, it doesn't. And to understand that, we have to think about how tips get reported to an employee versus to an independent contractor. So your typical server in a restaurant is a W-2 employee of the restaurant. So customers are paying the restaurant with credit cards and debit cards, and they're leaving tips that are charged to those cards. Think about who gets the 1099K in that situation if one is issued at all. The answer is the restaurant gets it. And the fact that tips are not separately stated is not the end of the world because it's not the restaurant that's taking the deduction, it's the employees. So the restaurant is gonna have to track along the way the tips paid to employees and make sure that those tips run through payroll along the way and then get reported in box twelve of the W two that's issued to the employee. So the 1099K stuff that we've talked about has no impact on employees. The restaurant has to track the qualifying tips in some way. It doesn't really matter how.