Earlier this month, President Trump signed the “One Big Beautiful Bill” (OBBB) into law, which contains two key provisions that are likely to be very popular with employees. Those provisions provide federal income tax deductions on both tips and qualified overtime compensation for tax years 2025 – 2028. However, these changes also bring important new reporting and compliance responsibilities for employers, who must adjust payroll processes and tax filings accordingly.
Prior to the new law, the Internal Revenue Service (IRS) treated all tips – whether cash or non-cash –as taxable income. Tips had to be reported to employers and were subject to federal income tax as well as Social Security and Medicare taxes.
The new law maintains those basic rules but introduces a federal income tax deduction for certain tips beginning in the 2025 tax year (starting January 1, 2025). Specifically, employees who “customarily and regularly receive tips” as of December 31, 2024, may deduct up to $25,000 in tip income from their federal taxable income. The Treasury Secretary (or a delegate) is required to publish a list of qualifying tipped occupations.
This deduction phases out for higher earners—beginning at a modified adjusted gross income of $150,000 (or $300,000 for joint filers)—and is reduced by $100 for every $1,000 over that threshold. Notably, this deduction is available to all qualifying taxpayers, including those who take the standard deduction. However, it does not affect Social Security or Medicare taxes, which still apply to all tip income.
The law also expands eligibility for the FICA tip credit, which allows employers to reduce their business income taxes by the amount they pay in the employer share of Social Security and Medicare taxes (currently 7.65%) on qualified tips. Previously, only tips earned by employees in food and beverage service establishments where tipping is customary qualified. The new law broadens this to include beauty service businesses, such as barber shops, hair and nail salons, esthetic services, and spas—provided that tipping is customary.
Here’s what employers need to know about tip reporting and compliance:
- Employers must report both cash and non-cash tips, along with the employee’s occupation, on each employee’s Form W-2.
- Businesses must separately report tip amounts and recipient occupations on Forms 1099 for tipped independent contractors.
- Social Security and Medicare taxes still apply to all reported tips. Employers should continue withholding and paying these taxes as usual.
- The IRS is required to revise tax forms and withholding procedures to reflect the new tip deduction and reporting rules, but no guidance has been issued yet.
- Employers in beauty and personal care industries—such as salons and spas—may now claim the FICA tip credit if tipping is customary.
- The structure of the FICA tip credit remains the same for existing qualifying businesses (e.g., food service), but eligibility has broadened.
Section 70202 of the new law introduces a federal income tax deduction for “qualified overtime compensation.” This term refers to overtime pay that exceeds an employee’s regular rate of pay, as required by Section 7 of the Fair Labor Standards Act (FLSA). Employees will be able to deduct up to $12,500 in overtime wages from their taxable income (or $25,000 for joint filers).
The deduction does not apply to overtime premiums paid solely under state laws or collective bargaining agreements. Like the tip deduction, it does not affect Social Security or Medicare taxes, which must still be withheld and paid on the full amount of wages.
Here’s what employers should know about overtime reporting and compliance:
- This deduction is available in addition to the standard deduction, so employees do not need to itemize to benefit.
- Employers must report the total amount of qualified overtime pay on employees’ Forms W-2.
- For independent contractors, businesses must report the amount of qualified overtime compensation on the relevant Forms 1099—even though, under the statute, “qualified overtime compensation” specifically refers to payments made to individuals under the FLSA.
- The IRS is directed to revise withholding procedures and tax forms to accommodate the new deduction.
- Notably, for tax year 2025, the law allows businesses to reasonably estimate qualified overtime amounts, using a method to be defined by the Treasury Secretary.
As of now, the IRS has not yet issued formal guidance on how these changes will be implemented.
This article appeared in the August 4, 2025, issue of The Journal Record. It is reproduced with permission from the publisher.