On Independence Day, 2025, President Trump signed into law the One Big Beautiful Bill Act. This 330-page act covers a great deal, most of which will not be discussed in this article, but since it does have an impact on the payroll world, I will review pertinent items including the no tax on tips and overtime provision and the retroactive change to the Employee Retention Tax Credit.
Employee Retention Tax Credit
For ERTC, there will be no credit allowed for claims involving the 3rd and 4th quarter 2021, filed after January 31, 2024. This is somewhat good news, as Congress was originally looking to end ERTC filing early for all tax quarters. The audit period for claims has been extended from five years to six, giving the IRS an extra year to identify any claims that may have been fraudulently filed.
No Tax on Tips and Overtime
The no tax on tips and overtime will be handled on the personal tax returns of the individuals as an above-the-line deduction, for tax years 2025 through 2028, and it appears that those two items will need their own reporting on the W-2 form. Those earnings will only be exempt from federal income tax and still be subject to Social Security and Medicare tax (FICA,) as well as state and local income tax. We will cover the details of each one below.
Overtime Wage
For tax years 2025 through 2028, there will be a new deduction for “qualified” overtime pay, defined as compensation paid to an individual required by section 7 of the Fair Labor Standards Act (FLSA) in excess of the regular rate of pay. This means that for an employee who earns $10 per hour as their regular rate of pay, and they were to work 1 hour of overtime, their pay rate would be $15 per hour. The amount that would not be taxable is $5, which is the amount that is in excess of the regular rate of pay.
If an employer pays overtime outside of the requirements of FLSA, for example, a union agreement inclusive of daily overtime or double time, or if there is a state-required overtime, for example in California, there are all sorts of cases where overtime is required (hours in a day and/or consecutive days,) then those examples of overtime DO NOT meet the definition of qualified overtime and are not subject to this rule. This will have a significant impact on employers in regards to how payroll is handled. For those who pay FLSA overtime AND, let’s call it non-FLSA overtime, then you will need separate Overtime earnings categories. This way, you can report the proper overtime amount on the W-2 form at year-end. Since this is a retroactive change to January 1, 2025, there is a transition rule, under which the amounts reported for 2025 may approximate a separate accounting by any reasonable method specified by the Secretary. We will find out more about this in the coming weeks and months. In the meantime, you may want to start separation of overtime earning categories.
The deduction will be limited to $12,500 for an individual. A married filing joint couple will be able to deduct $25,000. The deduction will phase out, starting at an Adjusted Gross Income (AGI) for an individual earning $150,000, or $300,000 for married filing joint filers.
Tips
Qualified tip income will also be deducted from AGI, for tax years 2025 through 2028, for workers in industries that customarily receive this income. A list of industries will be provided by the U.S. Treasury by October 2, 2025. Certainly, restaurants and food service establishments will be on the list, but we will likely find attorneys, for example, not on the list. I think you get the idea. The term ‘qualified tips’ is also going to be a bit tricky for some to administer and track. These are tips that are defined as being voluntarily paid by the customer and are not subject to negotiation or policy set by the employer. For example, it is not uncommon to find a restaurant that has an “automatic 18% tip for parties of 6 or more. Uh Oh! That is not a voluntary tip and not deductible, and now needs to be tracked separately.
The deduction of tips income will be limited to $25,000 for an individual and a married filing jointly couple will able to deduct $50,000. The deduction will phase out by 10%, starting at an Adjusted Gross Income (AGI) of $150,000 for an individual and $300,000 for married filing joint filers, reduced by $100 for every $1,000, or fraction thereof, above those thresholds.
Tips and Overtime Conclusion
For employers who pay overtime and have tipped employees, subject to the deduction, you will be faced with the question, why are there still taxes being deducted on those earnings? If you did not catch my earlier paragraph as to how this is handled, let me reiterate. The deduction/exemption is handled on their personal 1040 tax return as an above-the-line deduction. This means that on their paycheck, the employee will have federal income tax withholding on all taxable earnings, INCLUDING these “non-taxable” earnings of tips and overtime. The employee will receive a somewhat larger income tax refund when they file their year-end taxes. For employees who earn a significant amount of tips and/or overtime, they may want to adjust their W-4 to reduce the amount withheld on a per paycheck basis. We may find in future years, starting in 2026, the income tax withholding calculation may account for this, but not for this year.
While we make every attempt to ensure the accuracy and reliability of the information provided in this document, the information is provided “as-is” without warranty of any kind. Romeo Chicco or PayMaster, Inc. does not accept any responsibility or liability for the accuracy, content, completeness, legality or reliability of the information contained. Consult with your CPA, Attorney, and/or HR Professional as federal, state, and local laws change frequently. This Act is brand new and many details will continue to be worked out by the appropriate government agencies.
