What the new “no tax on tips and overtime” rules mean for employers and workers
A major provision of the One Big, Beautiful Bill is turning heads across the service industry and among small business owners: a new federal tax exemption on tips and overtime pay.
As the Senate version of the bill clears a major hurdle and nears final reconciliation with the House, it's time to unpack what this means for employers, employees, and the broader economy.
A look at the core provisions
The Senate and House versions of the tax reform both support eliminating federal income taxes on:
- Tips: Up to $25,000 per year for joint filers (or $18,500 for individuals).
- Overtime: Up to $12,500 per year (or $25,000 for joint filers).
These deductions are:
- Above-the-line, meaning they reduce gross income.
- Limited to workers with modified adjusted gross income under $150,000 ($300,000 for joint filers).
- Available only to married couples filing jointly.
- Set to apply retroactively starting January 1, 2025, and expire after December 31, 2028.
NOTE! These are income tax deductions only – Social Security and Medicare (FICA) taxes still apply, and employers must continue withholding them.
Who qualifies for the deductions?
Tip deduction requirements
- Tips must be voluntarily paid in occupations that customarily receive tips (e.g., servers, bartenders, hairstylists).
- Tips must be reported on Form W-2, Form 1099, or Form 4137.
- Treasury will publish an official list of qualifying occupations within 90 days of enactment.
Overtime deduction requirements
- Overtime must be paid in compliance with the Fair Labor Standards Act (FLSA): i.e., 1.5x the regular hourly rate.
- It must exceed regular rate pay and cannot be double-counted with tips.
Some industries – such as accounting, law, financial services, and performing arts – are excluded from the tip deduction.
What employers need to do
Reporting requirements
Starting in 2026, employers must:
- Report qualified tips and overtime separately on Forms W-2 and 1099.
- Identify whether tips are from “customary” occupations.
- Prepare for updated IRS withholding tables and likely changes to Forms W-2, 1099, and W-4.
For 2025, businesses may use a transition rule that allows them to approximate tip and overtime amounts using a “reasonable method.”
Administrative challenges
There’s still ambiguity about:
- How employers should distinguish qualified vs. general overtime, especially with varying state labor laws.
- Whether workers without official 1099s can still deduct tips (e.g., using Form 4137).
- How thresholds for 1099 reporting (raised to $2,000 under OBBB) affect deduction eligibility.
- Whether states will mirror the federal exemption for state tax purposes.
Economic and labor implications
Worker support and concerns
While 83% of restaurant workers reportedly support the tip tax break, many still earn too little to benefit due to the subminimum wage model.
Most tipped workers earn under the standard deduction threshold, making their income non-taxable to begin with.
“More tipped restaurant workers would lose their Medicaid than would gain small tax benefits,” – Saru Jayaraman of One Fair Wage
Benefit cuts and work requirements
The tax savings for workers arrive alongside deep cuts to federal safety nets, including:
- Medicaid: New work requirement of 80 hours/month for adults aged 19–64.
- SNAP: Senate bill cuts $211 billion over 10 years, reducing food assistance access for millions.
With many restaurant workers facing unstable hours, they may fail to meet eligibility thresholds – even if they want to work more.
Tipping trends and emerging risks
The rise of digital tipping
Cash tips are vanishing, replaced by credit card, app-based, and POS system tipping – creating digital records that the IRS can more easily track.
- A Babson College report notes that digital tips have driven a rise in tax enforcement, fueling demand for this exemption.
- The bill could incentivize tipping in new industries, such as landscaping, home repair, or delivery services, as businesses seek to reclassify income.
Risk of employer misuse
Tax professionals caution against manipulating compensation structures to over-rely on tips or mislabel service charges. Misclassification could trigger audits or labor law violations.
The big picture: what to watch
Still to be resolved
IRS and Treasury guidance on:
- Form changes
- Coding for qualified tips/overtime
- Verification for occupations
What smart employers should do now
- Begin preparing payroll and time tracking systems for additional reporting.
- Educate HR/payroll teams on qualifying pay structures.
- Anticipate software updates needed in 2026.
- Consult tax professionals before altering compensation models.
Final thoughts: Opportunity with responsibility
For some workers – especially in higher-end service roles – this provision could provide thousands in annual tax relief.
For others, particularly those earning near or below poverty levels, it may offer little actual benefit while stripping away critical safety-net protections.
For employers, it presents both opportunity and responsibility: a chance to attract and retain talent more effectively, while staying compliant in a new tax landscape.
