Our Key Takeaways
- Learn what’s changed: The One Big Beautiful Bill Act allows employees to deduct up to $25,000 in qualified tips and $12,500 in qualified overtime premiums from taxable income.
- Understand your role: Employers must now track, report, and document qualified vs. non-qualified tips and overtime accurately to remain compliant.
- Prepare early: Update payroll systems, strengthen recordkeeping, and train your team before the 2025 tax season to avoid costly adjustments later.
Do you employ staff who earn tips or overtime pay? The IRS has issued temporary guidance on how these new deductions should be handled under the One Big Beautiful Bill Act.
Previously fully taxable, tips and overtime pay can now qualify for individual income tax deductions. Tis gives millions of American workers a boost in take-home pay. However, while this offers relief for employees, it also introduces new compliance responsibilities for employers – particularly in hospitality, retail, and healthcare.
This blog breaks down what you need to know to stay compliant and how to prepare your payroll and accounting systems ahead of the 2025 tax season.
How the New IRS Tip & Overtime Deduction Rules Work
Until now, tips and overtime pay were treated like any other wage – fully taxable for income, Social Security, and Medicare purposes. That changes under the One Big Beautiful Bill Act, which introduces a temporary deduction for employees who earn tips or overtime pay.
The IRS has issued temporary guidance to help employers navigate what qualifies, what doesn’t, and how to report these earnings accurately. This guidance is designed to help employers understand how these new employee deductions work in practice—and what needs to be tracked to support accurate reporting.
Under the One Big Beautiful Bill Act, workers can now deduct up to $25,000 in qualified tips and $12,500 in qualified overtime premiums from their taxable income.
Key Provisions of the Temporary Guidance
While employees can claim these deductions on their personal tax returns, employers are responsible for accurately tracking, reporting, and documenting additional pay. Here’s what to know to keep your business compliant and support your employees through the transition.
What Counts as a Qualified Tip Deduction?
Tip income stays on the books as usual. It’s just that your employees may now be eligible to claim up to $25,000 in qualified tips as a deduction when filing their personal tax returns.
- The challenge: added tracking responsibilities. You’re still required to report all tips as regular wages, but now you also need to separate qualified from non-qualified tips for accurate reporting.
- The solution: work with your payroll practitioner or accountant to create a temporary process (custom reporting fields or manual logs) to track both categories until the IRS releases formal updates.
So, what’s the difference?
The IRS has indicated that qualified tips include those voluntarily given by customers in industries where tipping is customary – such as restaurants, hospitality, salons, and certain service roles. These tips must be reported, traceable, and subject to regular payroll withholding.
Non-qualified tips, on the other hand, are expected to cover amounts that fall outside those criteria. For example, mandatory service charges, automatic gratuities, or any payments not processed through standard payroll channels.
This distinction is designed to prevent abuse of the deduction and ensure that only genuine, reported tips qualify for the employee tax break. While the IRS is still finalizing the full list of covered occupations and reporting rules, starting to categorize tips under these two broad buckets now will help your business stay compliant.
To stay ahead, make sure your payroll system accurately captures daily tip data and that employees record tips consistently. The IRS is expected to clarify acceptable documentation soon, but keeping detailed records now will prevent complications later.
Even though employees can deduct qualified tips, you’re still required to withhold Social Security and Medicare taxes on the full amount. The key change lies in how the income is reported, not how it’s paid.
How the New Overtime Deduction Works (And What to Track)
The same principles apply to overtime pay. While it remains fully taxable through payroll, employees can claim a deduction of up to $12,500 in qualified overtime premiums on their personal tax returns.
Only the extra pay employees earn for working more than 40 hours in a week qualifies. We refer to this as the overtime premium – the extra half-time rate employers pay on top of an employee’s regular hourly wage.
Here’s how it works: if an employee earns $20 an hour, and you pay time and a half for overtime, those extra hours are paid at $30 an hour ($20 regular pay + $10 overtime premium). Only the $10-per-hour premium portion qualifies for the deduction.
This change doesn’t alter how you calculate overtime under the Fair Labor Standards Act (FLSA); it only affects how that income is treated for federal tax purposes. Accurate documentation will be critical once the IRS finalizes new reporting rules, which may include new W-2 codes. Start tracking overtime data now to ensure compliance once the final framework takes effect.
5 Employer Action Steps to Stay Compliant
You understand the rules; now it’s about getting the implementation right. The IRS’s temporary guidance may focus on employee deductions. However, it also places new responsibilities on employers to track, report, and document pay correctly. Here’s what to prioritize to keep your payroll processes aligned and ready.
- Review payroll policies and systems.
Check how your payroll software tracks tips and overtime. Most systems can’t yet separate qualified from non-qualified amounts. Therefore, you may need to create custom fields or maintain manual logs until updates are released. Because the law is retroactive to January 1, 2025, review prior payroll runs for accuracy.
- Strengthen recordkeeping.
Record daily tip data and overtime premiums consistently. Reliable bookkeeping now will make it easier to apply new IRS reporting standards once finalized. If automation isn’t available, work with your CPA to set up a simple manual tracking process.
- Stay alert for IRS updates.
Expect further IRS guidance and possible updates to W-2 forms to capture qualified tips and overtime. Monitor IRS announcements regularly.
- Communicate with employees.
Explain that while their paychecks won’t change immediately, they may qualify for deductions when filing their personal returns. Inform staff as new details are released.
- Partner with an expert.
Tax professionals and CPAs can help configure payroll systems. The also validate records and ensure your compliance strategy aligns with evolving IRS rules.
Get Expert Support Before the 2025 Tax Season
Precision matters when it comes to payroll compliance and tax preparation. Fusion CPA helps businesses streamline payroll, strengthen documentation, and stay IRS-ready.
Schedule a discovery call today to ensure your business is compliant, confident, and ready for the 2025 filing season.
Frequently Asked Questions
1. What is the One Big Beautiful Bill Act and how does it affect employers?
The Act, signed into law on July 4, 2025, introduces new employee deductions for tips and overtime pay. Employers are responsible for updating payroll systems to track and report these amounts correctly.
2. Which tips and overtime payments qualify for the new deductions?
Only voluntary, reported tips and the overtime premium—the extra half-time pay above an employee’s regular hourly rate—qualify. Mandatory service charges or unreported cash tips do not.
3. What steps should employers take to stay compliant?
Review payroll configurations, document daily tip and overtime data, communicate with staff, and monitor IRS updates. Partnering with a CPA or payroll expert ensures your business remains compliant as the IRS finalizes new reporting requirements.
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This blog does not provide legal, accounting, tax, or other professional advice. We base articles on current or proposed tax rules at the time of writing. We do not update older posts for tax rule changes. Our team disclaims all liability regarding actions taken or not taken based on the contents of this blog. The same goes for the use or interpretation of this information. This website does not provide all-inclusive information, and you should not rely on it as such.