Navigating Tip and Overtime Deductions Under the OBBBA: What Employers Need to Know Now

No Tax on Tips
Effective for tax years 2025 through 2028, Section 70201 of the OBBBA introduces a new above-the-line deduction for individuals who receive qualified tips. The deduction applies to voluntary tips, whether cash or charged, including those received through lawful tip-sharing arrangements, provided they are properly reported on a Form W-2, Form 1099, or Form 4137.

The annual deduction is capped at $25,000 and begins to phase out at $150,000 of modified adjusted gross income (MAGI), or $300,000 for joint filers. For self-employed individuals, the deduction is limited to the net income from the relevant trade or business (excluding the deduction itself).

To qualify, tips must be:

• Voluntary, non-negotiated, and customer-determined;
• Earned in occupations the IRS deems as customarily tipped (based on conditions as of December 31, 2024); and
• Excluded if earned in or through a Specified Service Trade or Business under §199A, including law, health care, and consulting.

Employers and other payors must report the total amount of qualified tips and the recipient’s occupation on year-end tax forms. The IRS is required to publish a list of qualifying occupations by October 2, 2025, and has authority to issue regulations to prevent misclassification or abuse. For tax year 2025, reasonable estimation methods are permitted for both reporting and deduction purposes, pending further guidance.

Implications for Employers
To prepare for Section 70201, employers should take several key steps to align with the new rules and mitigate compliance risks. Suggested actions include:

• Review Tip Pooling and Classification. Reassess tip-sharing arrangements to ensure compliance with federal and state law. Avoid including roles that do not qualify for tipping under state and federal legal standards.
• Evaluate Compensation Practices. The deduction may widen the gap between tipped and non-tipped employees, particularly in high-wage jurisdictions. Employers should consider whether adjustments are needed to promote retention and fairness.
• Update Payroll and Reporting Systems. Employers must accurately report total qualified tips and employee occupations on wage statements and year-end forms. Systems should be adapted to capture these data points consistently, using tools like POS and time-tracking software. Employers should consult with their payroll vendors to make adjustments.
• Understand Industry-Specific Changes. Section 70201(e) expands the FICA tip credit to beauty and spa services. Businesses in these industries should review how tips are tracked and ensure compliance with both tax and labor laws.

Establishing clear policies and documentation practices now will position employers to take full advantage of the deduction while minimizing audit exposure.

No Tax on Overtime
Effective for tax years 2025 through 2028, Section 70202 of the OBBBA creates a new above-the-line deduction for individuals who receive qualified overtime compensation. The deduction applies to the “premium” portion of overtime pay, as defined under Section 7 of the Fair Labor Standards Act (FLSA)that requires employers to pay time-and-a-half for hours worked in excess of 40 per week.

The maximum deduction is $12,500 per year, or $25,000 for joint filers, and is available to both itemizing and non-itemizing taxpayers. The deduction is subject to phase-out beginning at $150,000 of MAGI, or $300,000 for joint filers, with the deduction reduced by $100 for every $1,000 of MAGI above the threshold.

To qualify, overtime compensation must be:

• Mandated by the FLSA’s federal time-and-a-half rules, i.e., only the FLSA-mandated premium portion of overtime above the base pay rate is qualified overtime compensation;
• FLSA overtime separately identified on Form W-2 (likely in a new field); and
• Excluded from the separate W-2 reporting requirement if not mandated by the FLSA (e.g., excess overtime pay based solely on more generous state or local wage laws such as California’s daily or double-time pay provisions, or overtime paid to exempt employees under contractual arrangements).

Employers and other payors are required to report the total amount of qualified overtime compensation on year-end tax forms. For tax year 2025, the IRS will permit the use of reasonable methods for approximating the overtime pay that must be separately reported in Form W-2, pending the issuance of further guidance.

Implications for Employers
In anticipation of Section 70202, employers should take proactive measures to comply with the new requirements and optimize potential tax benefits. Suggested steps are

• Reevaluate Employee Classification. Some employees may request to shift from exempt to non-exempt status to take advantage of tax-free overtime pay. Employers should carefully evaluate such changes to ensure compliance with wage and hour laws and avoid potential misclassification risks.
• Review Compensation Structures. With up to $12,500 ($25,000 for joint filers) in eligible deductions, employers may consider restructuring base pay to allow more FLSA-compliant overtime without increasing total payroll costs.
• Update Payroll and Tracking Systems. Employers must separately track and report the premium portion of federally required overtime on Form W-2. Systems must distinguish this federal portion from state-mandated or contractual overtime, which does not qualify.
• Apply Transition-Year Estimation. For 2025, employers may use reasonable methods to estimate qualified overtime compensation, pending final IRS guidance.

Establishing proper payroll protocols and clearly documenting employee classifications will help employers and workers maximize the benefit while remaining compliant.

Special Considerations for California Employers
California employers face unique compliance challenges under the OBBBA, particularly with the federal overtime deduction in Section 70202. California’s overtime rules exceed federal standards, therefore much of the state-mandated overtime, such as daily OT (after 8 hours per day), double-time (after 12 hours per day), and seventh consecutive day premiums, does not qualify for the federal deduction. Only FLSA-required overtime, meaning hours worked beyond 40 in a workweek, is eligible.

Pointers for California Employers

California’s broader wage laws limit the scope of the federal OT deduction. To navigate this complexity, California employers should:

• Dual-Track Overtime. Distinguish FLSA-qualifying OT from California-only OT in payroll systems. Use internal payroll codes or tracking tools.
• Update Payroll and Year-End Reporting. Work with your payroll provider to ensure wage statements and W-2s clearly separate deductible (FLSA) overtime from non-deductible OT.
• Avoid Classification Missteps. Evaluate carefully before reclassifying exempt workers as non-exempt to access the deduction. Misclassification risks remain high under California law.
• Don’t “Engineer” Overtime. Adjusting schedules or flattening base pay to boost qualifying OT could trigger wage/hour violations.
• Align Tip & OT Policies. California’s tip rules (e.g., Labor Code §351) and state overtime laws must be considered when integrating new tracking systems.
• Communicate Transparently. Educate employees on OT deduction distinctions to manage expectations and ensure compliance.

To learn more about these developments, Pillsbury is hosting roundtables discussing updates relating to executive compensation, payroll, and health and welfare benefits. To view our roundtable on Executive Compensation and Payroll Key Developments, click here. To register for our August 14 roundtable on Health and Welfare Benefits Key Developments, click here.