IRS Issues New Guidance on “Tips & Overtime” Deductions

On November 21, 2025, the Internal Revenue Service (IRS) released guidance under the One, Big, Beautiful Bill Act (OBBBA) that impacts tipped workers and overtime-eligible employees for the 2025 tax year.

As a payroll provider, we believe it’s critical you understand what this means now — both for your payroll operations and for employees who tip, work overtime, or both.

What the New IRS Guidance Contains

Qualified Tips — Potentially Tax-Deductible

Eligible tipped employees may now deduct up to $25,000/year in “qualified tips,” through 2028.
If total tips plus cash wages are already reported on standard wage forms, employees can use those amounts — but many employers may choose to supply a separate accounting instead (e.g., via Box 14 on the W-2 or a separate statement).
For 2025 only, the IRS is treating this as a “transition period”: employers are not required to separately report tips or overtime compensation, and failure to do so will not be penalized.

Qualified Overtime — Partially Tax-Deductible

For non-exempt, overtime-eligible employees under the Fair Labor Standards Act (FLSA), the “premium” portion of time-and-a-half pay (typically the “half-time” portion) may qualify for a deduction.
The deduction limit for overtime is up to $12,500/year (or $25,000 for joint filers), subject to phase-outs above income thresholds.

Key Limitations & Transitional Framework

The deduction applies only to tips and overtime under current federal law (FLSA), not additional premiums mandated by state law or collective bargaining agreements.
Because the standard wage-reporting forms (W-2, 1099, etc.) have not yet been updated for 2025, employers have flexibility — but also uncertainty — whether to report tip/overtime breakdowns separately this year.

Why This Matters for Employers

Even if your workforce isn’t in a typical “restaurant” setting, many of your clients may employ tipped or hourly-plus-overtime workers (e.g., service staff, laborers, contractors, trade helpers). Here’s why this guidance should be on your radar:

Reporting choices affect employee tax benefits.
If employers supply separate tip/overtime breakdowns (e.g., through Box 14 or a portal), workers get the data they need to claim deductions, which may improve employee satisfaction and reduce turnover.
Flexibility this year — but likely change in 2026.
The 2025 transition year gives employers breathing room, but forms are expected to be updated for 2026. Systems and procedures should be readied now.
Payroll systems may need updates.
To enable separate accounting for cash tips or overtime premiums (or breakdowns required under future IRS rules), your payroll software may need configuration or manual adjustments.
Clear communication is critical.
Because reporting is optional in 2025, employers who choose not to break out tips or overtime should inform staff, so employees understand how — or whether — they can claim deductions.

What Employers Should Do Now

Review your workforce: identify tipped positions, hourly + overtime-eligible roles, and staff who rely heavily on overtime or tips.
Decide whether to provide separate tip/overtime breakdowns (Box 14, portal, statements). Even though optional in 2025, voluntary reporting helps employees.
Verify your payroll system can support separate accounting or prepare manual processes if needed.
Communicate with employees: clarify what data they’ll receive (or not), and how that affects potential tax deductions.
Monitor further IRS updates, and be ready for form changes and required reporting beginning in 2026.

Our Recommendation to You

At Baron Payroll, we recommend voluntary tip- and overtime-breakdown reporting starting now, even though not required — especially if you support businesses that involve tipped work or frequent overtime. It supports transparency, helps workers take advantage of new tax deductions, and positions your payroll system to meet 2026’s likely reporting standards.

Need Help with Your Payroll for 2026?

Baron Payroll clients count on us to keep their business compliant — no guesswork, no stress, no last-minute scrambling. If you want help reviewing your pay rates, tipped-employee rules, or exempt thresholds, we’re here for you.

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