Income and Assets · Income

Taxability of wages, salaries and other earnings

Compensation for services is gross income (IRC § 61(a)(1)), and that sentence settles most of what arrives in an intake interview about earnings — whoever paid it, whatever it was called, however it was delivered. What 2026 changes is not that rule but what happens next: two new deductions turn the characterisation of a payment as a tip, as overtime, or as neither into an arithmetic question rather than a labelling one, and they do so with a definition of “tip” that the Code has never carried before.

The rule

The base rule reaches more than a wage. Gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items (IRC § 61(a)(1)). The employment tax definitions are narrower and serve a different purpose: an employee for social security and Medicare is defined at IRC § 3121(d), which reaches common-law employees and, separately, four categories of statutory employee — agent-drivers and commission-drivers distributing certain goods, full-time life insurance salespeople, home workers working to specification on materials supplied and returned, and full-time travelling or city salespeople soliciting for a principal (IRC § 3121(d)(3)(A)–(D)). A statutory employee is an employee for those taxes while reporting earnings as a business, which is why the category exists at all.

Tips are wages, with a floor. Cash tips are excluded from wages only where they are below a monthly threshold, and tips paid in any medium other than cash are excluded from wages entirely (IRC § 3121(a)(12)(A), (B)). Every employee receiving tips that are wages in a calendar month must report them to the employer in one or more written statements by the 10th day of the following month (IRC § 6053(a)). Nothing in either provision makes an unreported tip non-taxable; they govern withholding and social security wages, not gross income.

The Code now defines a tip. Qualified tips are cash tips received in an occupation that customarily and regularly received tips on or before 31 December 2024, as provided by the Secretary (IRC § 224(d)(1)) — and the amount must be paid voluntarily, without any consequence for non-payment, not the subject of negotiation, and determined by the payor (IRC § 224(d)(2)(A)). A tip received in a specified service trade or business as defined in § 199A(d)(2) is excluded (IRC § 224(d)(2)(B)). This is the first time the distinction between a tip and a mandatory service charge has turned on statutory text rather than on ruling practice.

Two new deductions, with the same shape. A deduction is allowed for qualified tips included on the statements furnished under §§ 6041(d)(3), 6041A(e)(3), 6050W(f)(2) or 6051(a)(18), or reported by the taxpayer on Form 4137 (IRC § 224(a)); and for qualified overtime compensation included on the statements furnished under § 6041(d)(4) or § 6051(a)(19) (IRC § 225(a)). Each is capped and each phases out on modified adjusted gross income — defined for both as adjusted gross income increased by amounts excluded under §§ 911, 931 or 933 (IRC §§ 224(b)(2)(B), 225(b)(2)(B)). Each requires the individual’s social security number on the return (IRC §§ 224(e), 225(d)). Each applies to a married taxpayer only if a joint return is filed (IRC §§ 224(f), 225(e)). And each terminates after 2028 (IRC §§ 224(h), 225(g)).

Overtime is defined by labour law, not tax law. Qualified overtime compensation means overtime required under section 7 of the Fair Labor Standards Act of 1938 that is in excess of the regular rate at which the individual is employed (IRC § 225(c)(1)). Two things follow: overtime paid under a contract or a state law but not required by that section is not qualified, and only the premium element counts, not the whole overtime hour. Qualified tips are excluded from qualified overtime, so the same dollar cannot serve twice (IRC § 225(c)(2)).

Self-employed tips are limited to profit. Where qualified tips arise in a trade or business other than performing services as an employee, they count only to the extent gross income from that business exceeds the deductions allocable to it (IRC § 224(c)).

Current figures

How it works in practice

Start from the proposition that everything received for services is income, then work out its character. The characterisation questions that matter now are narrower and sharper than they were: is this a tip within § 224(d), is this overtime within § 225(c), and is the taxpayer’s occupation one the Secretary has listed. A payment can be plainly taxable and plainly not deductible, and saying both to a client in the same sentence avoids a common disappointment.

For a tipped employee the working sequence is: confirm the occupation qualifies; separate voluntary tips from mandatory service charges, because the latter are wages and outside § 224 entirely; confirm the amounts appear on the statements the section requires, since the deduction is defined by reference to those statements rather than to the tips themselves; then apply the cap and phase-out.

For overtime, ask what law required the premium. Section 7 of the Fair Labor Standards Act is the test, so a salaried employee exempt from that section who receives extra pay for extra hours has no qualified overtime, however the employer describes it. And because only the excess over the regular rate counts, the deductible figure is a fraction of what the client thinks of as their overtime pay — the employer’s statement under § 6051(a)(19) is what settles it.

Two administrative points belong in the interview. Both deductions require a social security number on the return, so an ITIN filer has neither. And both are unavailable to a married taxpayer filing separately, which can outweigh whatever drove that filing choice.

How this has changed

Both deductions are new, added by Pub. L. 119-21 §§ 70201(a) and 70202(a), and 2026 is a full first year for each. Nothing equivalent existed before, so there is no prior treatment to compare against — the change is the arrival of the provisions, and the risk is not staleness but overstatement.

The overstatement to guard against is the popular framing. Neither section exempts anything. Both sit below the line, leaving the amounts in gross income, so a client whose tips are entirely deductible still has those tips counted for every adjusted-gross-income threshold on the return — including the phase-outs of these very deductions, which are computed on modified adjusted gross income that starts from adjusted gross income and adds back the §§ 911, 931 and 933 exclusions.

The reporting machinery arrived with them. IRC § 6051(a)(18) and (19) add cash tips with the § 224(d)(1) occupation, and qualified overtime compensation, to the employee’s wage statement; § 6050W(f)(2) was amended to require a separate accounting of payor-designated cash tips. Because § 224(a) and § 225(a) define the deduction by reference to amounts included on those statements, an employer’s failure to report correctly is not a formality — it removes the deduction.

Finally, both provisions carry the same sunset. A deduction unavailable for any taxable year beginning after 31 December 2028 is a planning fact as much as a compliance one, and any material describing either as a permanent change to the treatment of tips or overtime is wrong.

Exam focus

Expect the tip-versus-service-charge distinction, and answer it from IRC § 224(d)(2)(A) — voluntary, no consequence for non-payment, not negotiated, determined by the payor. All four limbs matter.

Know that qualified overtime is defined by section 7 of the Fair Labor Standards Act and reaches only the excess over the regular rate. That two-part answer is the whole of most questions on it.

Know the four common conditions on both deductions: a cap, a phase-out on modified adjusted gross income, a social security number, and a joint return for married taxpayers — plus the 2028 sunset.

The statutory employee categories in IRC § 3121(d)(3) are a stable, list-based question. Know that the consequence is employment taxes at source with business reporting of the earnings.

Check yourself

1. A restaurant adds an 18 percent charge to every bill for large parties and distributes it to servers. Is a server’s share a qualified tip?

Answer: no. IRC § 224(d)(2)(A) requires the amount to be paid voluntarily without any consequence for non-payment, not to be the subject of negotiation, and to be determined by the payor. A compulsory charge set by the restaurant fails each limb. The share remains compensation for services under IRC § 61(a)(1) and is fully taxable; it simply cannot be deducted under § 224.

2. An employee subject to the Fair Labor Standards Act works 50 hours in a week at a regular rate of $20, receiving $30 an hour for the ten extra hours. How much is qualified overtime compensation?

Answer: $100. IRC § 225(c)(1) reaches overtime required under section 7 of the Act only to the extent it is in excess of the regular rate. The premium is $10 an hour over the $20 regular rate, across ten hours. The other $200 is ordinary compensation.

3. A married taxpayer with substantial qualified tips files separately because of a dispute with their spouse. What is the effect on the deduction?

Answer: it is lost entirely. IRC § 224(f) provides that where the taxpayer is a married individual within the meaning of § 7703, the section applies only if the taxpayer and spouse file a joint return. IRC § 225(e) does the same for overtime. This is a complete bar rather than a reduction, and it can outweigh whatever prompted the separate filing.

4. A client’s cash tips in March came to $14. Are they taxable, and must they be reported to the employer?

Answer: taxable yes, reported no. IRC § 3121(a)(12)(B) excludes cash tips of under $20 in a calendar month from wages, and IRC § 6053(a) requires reporting only of tips that are wages, so no statement is due for March. The tips remain compensation for services and so gross income under IRC § 61(a)(1), to be reported on the return.