IRS Updates Tip Deduction Instructions Mid-Season: What Tax Professionals Need to Know With Just A Few Weeks To Go

Sharon Kreider, CPA & Mark Seid, EA, CPA, USTCP

The IRS dropped a significant update in early March, posting revised Form 1040 instructions for the new Schedule 1-A — the form used to claim the OBBBA deductions for tips, overtime, seniors, and car loan interest. For tax professionals already deep into filing season, the timing is challenging. For some clients, the new rules may meaningfully reduce the Qualified Tips deduction they were expecting and could trigger amended returns.

A Narrower Definition of Net Income for the Self-Employed in Calculating the Tip Deduction

Under the OBBBA, a self-employed taxpayer’s tip deduction cannot exceed net income from the trade or business in which the tips were earned. Most practitioners assumed “net income” meant gross business income minus business expenses — a straightforward calculation – just use the net Schedule C or F amount reported on Schedule SE, Line 3. The updated instructions make clear that the IRS wants to go further.

The updated instructions (see page 104 of the Form 1040 instructions) now define “net income” for purposes of the tip deduction limitation with a broader interpretation of “deductions allocable” to a trade or business than many practitioners anticipated.

Net income is now calculated by subtracting not just Schedule C/F expenses, but also:

The deductible portion of self-employment (SE) tax
The self-employed health insurance deduction
Contributions to self-employed retirement plans (e.g., SEP-IRA, SIMPLE IRA, Solo 401(k))

These are all Schedule 1 deductions that appear above the line on the return — outside of Schedule C/F entirely. The result is a lower net income figure, which can reduce or eliminate the tip deduction for self-employed workers who are otherwise doing everything right: paying SE taxes, covering their own health insurance, and saving for retirement.

Before vs. After: The Net Income Limitation in Practice

The Scenario: Alex is an app-based delivery driver (independent contractor) with the following 2025 figures:

Gross business income (including tips): $52,000
Schedule C expenses (mileage, phone, supplies): $24,000
Deductible portion of SE tax: $1,978
Self-employed health insurance deduction: $7,200
Solo 401(k) contribution: $9,000
Qualified tips: $14,000

Calculating Net Income — Before vs. After Updated Instructions
Item	Before	After
Gross business income, including tips	$52,000	$52,000
Less: Sch C Expenses	-24,000	-24,000
Less: Deductible SE Tax	—	-1,978
Less: SE Health Insurance	—	-7,200
Less: Solo 401(k) Contribution	—	-9,000
Net Income	$28,000	$9,822
Applying Net Income Limitation
Qualified Tips	$14,000	$14,000
Net Income Limitation	28,000	9,822
Allowable Qualified Tips Deduction	$14,000	$9,822
Difference		$4,178

Tax practitioner planning: Watch for interaction effects. Maximizing a retirement plan contribution or deducting self-employed health insurance — both sound tax planning moves — can now inadvertently reduce the tip deduction.

Guidance Conundrum

The only substantive authority that exists on the Qualified Tips deduction is IRC §224. Proposed regulations issued in 2025 contradict the latest instructions for applying the net income limitation. Prop. Reg. §1.224-1(d)(4) includes an example of a self-employed manicurist with business income of $15,000 (and no other employment income) who received $20,000 in qualified tips. The example calculates the net income limitation at $15,000 and does not reduce it by other business related items.

The revised instructions follow similar logic applied to determining Qualified Business Income when considering a “deduction or loss properly allocable to” a trade or business. See §199A(c)(3)(B)(vii) and Treas. Reg. §1.199A-3(b)(1)(v).

Key Practice Implications

Review affected returns. If you filed early-season returns without applying the expanded net income limitation, those returns may need to be amended. If the client owed tax (as many self-employed individuals do), they may not have filed. Before filing any additional returns, confirm how your software is handling the revised instructions. Contact the client about the IRS update.

Bottom line for your practice. Should taxpayers follow the original 1040 instructions, the revised instructions, or the proposed regulations? Or should they wait for more guidance? Well…there are no new IRS notices or FAQs that resolve the net income definitional issue. The Schedule 1-A instructions remain the operative (and disputed) source. With April 15 approaching and no clarifying guidance in sight, the conservative approach is to apply the broader net income reduction as the instructions state — and flag those returns as candidates for amendment if the IRS later clarifies in a more taxpayer-friendly direction.