Reduction in Taxes on Tips and Overtime

by JPeters | August 7, 2025 2:32 pm

New above-the-line tax deductions were provisions in the recent federal budget bill

 

H.R. 1[1], branded as “One Big Beautiful Bill Act” (the Act) by the Trump Administration, included provisions that establish an above-the-line tax deduction for “qualified tips” and “qualified overtime compensation.” Both provisions will require employers to consider wage eligibility, reporting requirements, and, undoubtedly, a few other payroll administration issues as well.

 

Reduction of Taxes on Tip Income

Previously, all cash and non-cash tips received by an employee were considered income by the Internal Revenue Service[2] (IRS) and were subject to federal income taxes. Each calendar month, all tips received were also subject to Social Security and Medicare taxes, and employers were required to report quarterly.

This has changed. Section 70201 of the Act, which was signed by President Trump and became the law on July 4, 2025, says that employees who “customarily and regularly receive tips” can now deduct up to $25,000 in tip income from the total income subject to federal income tax. The deduction is available for the tax years starting January 1, 2025, through 2028 — the deduction phases out for individuals earning over $150,000 and at $300,000 for joint filers.

For the 2025 tax year, eligible employees can claim the deduction when they file their taxes by April 15, 2026 for income earned in 2025. The Act authorizes the reporting party to “approximate” the amount designated as cash tips using a “reasonable method” to be specified soon by the Secretary of the Treasury. Further guidance — including which specific service roles qualify under the new legislation — should also be available soon from the Treasury Department.

 

Actions For Employers relating to Tips

Operationally, many administrative tasks won’t change much, if at all. Tips will still need to be reported by employees to their employers and then reported by employers to employees on Form W-2[3], the Wage and Tax Statement. Tax withholding — Social Security, Medicare, and any state or local taxes — is unchanged and still reported quarterly on Form 941[4].

Payroll systems may need to be configured to reflect updated withholding tables and updated Form W-4[5], the Employee’s Withholding Certificate. For the 2025 tax year, the benefit would be estimated and claimed on the individual taxpayer’s income tax return, and retroactive system modifications are unlikely to be necessary this year.

Employers may now be considering adjustments to their “tip pool” arrangements to distribute more tip income to a larger number of employees. However, the federal rules[6] regarding tips and who may participate in a tip pool are strict. Until the Treasury Secretary provides further guidance on what tip income qualifies for deduction, employers are advised to exercise caution before making significant changes.

Additionally, states and municipalities often have their own regulations regarding tips and tipping pools. In New Hampshire, where Orr & Reno is located, tips are considered wages wholely owed to the tipped employee unless the employee “voluntarily and without coercion from his or her employer” agrees to participate in a tip pool or tip sharing arrangement. In Massachusetts, by comparison, employers are permitted to require tip pooling.

 

Reduction of Taxes on Overtime Pay

Section 70202 of the Act established a new tax deduction for “qualified overtime compensation.” Qualified overtime compensation is defined as “overtime compensation paid to an individual required under section 7 of the Fair Labor Standards Act[7]” and reported on Form W-2.

New Hampshire[8], like most states, entitles nonexempt workers to overtime pay at a premium rate – typically time and one-half – for hours worked in excess of 40 hours per workweek. Some states have different rules. Employers are encouraged to consult the Department of Labor’s Wage and Hour Division for state-specific guidance[9].

Before the signing of H.B. 1 into law, overtime pay was not reported separately from regular wages on Form 941 or Form W-2. The new law will require the separate reporting of total overtime wages paid on these forms. Employers will also need to report the total amount of qualified overtime compensation for nonemployees on Form 1099[10].

What are the specifics? Much like the tips proposal, employees will be permitted to deduct overtime wages — up to $12,500 for a single filer and $25,000 for joint filers — from their income subject to federal income tax. This deduction does not affect Social Security and Medicare taxes. The deduction only applies to wages paid that exceed the employee’s normal hourly rate. For example, an employee who earns $20 per hour regular time and $30 an hour for overtime hours can deduct $10 per hour in overtime pay.

The Act requires the IRS to update all relevant income tax withholding procedures and tax forms to incorporate this new deduction and permits businesses to approximate an amount designated as qualified overtime compensation “by any reasonable method” specified by the Secretary of the Treasury for the 2025 tax year. As with the provision for the reduction of taxes on tips, the overtime deduction expires at the end of 2028.

 

Actions For Employers relating to Overtime Pay

Most payroll systems already track overtime wages for purposes other than tax reporting. Still, some adjustments to these systems may be necessary to accurately capture overtime wages as defined by the new law. These software adjustments take time to program and implement, and because the legislation is retroactive to the beginning of 2025, it’s realistic to anticipate some administrative complexities when putting these changes into practice.

 

What Next?

While we await further guidance from the Secretary of the Treasury, employers with large groups of employees earning tipped or overtime wages are advised to review their payroll practices to ensure they are up to date and compliant. However, before making any substantive changes or adjustments to their employment and payroll systems and practices, employers should consult with legal counsel or other professional advisors. Well-informed and careful planning will help employers avoid penalties, build trust with their employees, and present these deductions as differentiators in a tight labor market.

If you have any questions or concerns about how these changes will impact your employment practices and payroll systems — and how to best utilize these legislative changes to your strategic advantage — don’t hesitate to contact Orr & Reno for assistance.

 

Steven L. Winer[11] and Meredith F. Goldstein[12]

Source URL: https://orr-reno.com/reduction-in-taxes-on-tips-and-overtime/

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