Tactical tips on taxing tips (and overtime)

Here are five things to know about this new exemption:

1. Tip talk

Chapter two of the OBBBA establishes new below-the-line deductions through 2028 for qualified tip and overtime (OT) income. Taxpayers may deduct up to $25,000 of qualified tip income and up to $12,500 of qualified overtime income ($25,000 for joint filers). There is a phase out component for individuals whose modified adjusted gross income exceeds $150,000 ($300,000 for joint filers). To be eligible for the tax deduction for qualified tip income, individuals must provide a work-eligible Social Security number for themselves and, if married, must file a joint federal tax return.

2. Who benefits?

Occupations that customarily and regularly receive tips prior to 2025 are eligible for the tip tax deduction. The IRS issued proposed regulations on Sept. 22, 2025, listing occupations that are eligible for the provision and include occupations in the food and drink services, ride-share drivers, beauty industries and other service-based professions. Note that the deduction is not available for workers tied to section 199A Specified Service Trades or Businesses which include industries such as healthcare, legal and performing arts. The tips must also be reported on IRS-approved forms, such as Form W-2, 1099-NEC, 1099-K and 4137 for them to be deductible.

Tips must be voluntary, non-negotiated and paid by the patron and can be paid by cash or charged. Tips received through tip-sharing or tip-splitting arrangements are also covered. Employer-mandated services charges, however, do not count as qualified tips. These generally are presented as automatic additions to a customer’s bill based on the number of people at a table, holidays or time of day.

For overtime deductions, employees must receive OT pay as defined by the Fair Labor Standards Act, that is pay for hours worked beyond 40 in a regular work week). Note that the deduction only applies to the amount paid in excess of their regular hourly rate, meaning, only half the portion of time and a half.

3. Exemption limitations

Notably, federal employment taxes such as federal unemployment tax (FUTA), Social Security, Medicare and income tax withholding, along with possible state and local income taxes and state unemployment tax (SUTA), with states having the ability to set their own employment tax rules, still apply to tip and OT earnings. Additionally, only a total annual amount of $25,000 (tips) or $12,500 (OT) per taxpayer can be deducted from federal income taxes. A tipped worker who earns $30,000 performing multiple jobs, for example, would only be able to claim a maximum tip exemption of $25,000 for a year.

The $150,000 phase-out was instituted for two reasons. The first is to limit the opportunity to low-income earners, and the second is to preclude clever ruses by potential opportunists to label themselves as “tipped workers,” preventing fraud.

4. Tactful tax tips on qualified deductions

Should taxpayers begin treating tip and OT tax exemptions as written in stone? Not yet.

The IRS and Treasury will be releasing more guidance soon. In the interim, employers and self-employed individuals can work on developing their tip and OT tracking systems. Employees who historically have earned tips or overtime, on the other hand, should be ready to update their Forms W-4, if desired.

5. Employers be aware

Despite the federal income tax exclusions, tax withholding and reporting of all required taxes is still needed. Qualified tips and overtime wages will be reported separately on Forms W-2, or by non-employers on Forms 1099 or 4137, and the exemption(s) can be claimed on the employee’s Form 1040. The deduction applies only to federal income taxes, meaning Social Security, Medicare, FUTA, and possible state and local income tax withholding and SUTA still apply.

• Tax withholding: Despite the deductions, OT and tip income are still required to be reported via Forms 941/944 and W-2, and regular withholding taxes must be paid to the IRS, states and localities, as applicable. Workers will then use the tip and OT amounts reported on their Forms W-2 to claim their exemption(s) on their individual federal income tax return.
• Employer reporting: Employers should continue to withhold all regular employment taxes from their employees’ wages. It’s possible that Form 941 reporting will remain as is, but tips and overtime will need to be separately reported on Forms W-2. This may show up as an additional box or in boxes 12 or 14. Employers will be required to track tip and overtime wages to ensure they are properly reported.
• Payroll system updates: Payroll systems may already track tips and OT wages for purposes other than tax, but new software mapping may also be required to capture the tips and OT wages for purposes of satisfying the requirements of the exclusion provisions. Typically, vendors require time to bring systems up to date and, given that the provision is retroactive to the beginning of tax year 2025, accurate reporting could be an issue for the year.
• Transition period: Since 2025 is the first year these new requirements apply and employers have not had enough time to comply and/or update systems, the IRS issued transitional guidance under Notice 2025-62. The Notice treats 2025 as a transition year for purposes of IRS enforcement and administration of the new tips and overtime reporting requirements. The penalty relief applies only to the extent that the person required to make the return or statement otherwise files and furnishes a complete and accurate return.

While not a requirement for penalty relief, the IRS encourages employers to provide employees with occupation codes and separate accountings of cash tips and overtime. Employers should provide employees with clear identification of their occupation, especially for multi-role workers. Voluntary reporting is especially valuable in restaurants and hotels where employees often receive a mix of cash tips, credit card tips, tip-outs, and service charges. Providing clear breakdowns will help workers accurately calculate their deductions and avoid under- or over-claiming amounts. For 2025, it is recommended employers provide this information via a separate statement rather than in box 14 of Form W-2.  

• Tip credit: The new tip legislation broadens a tax credit to include employers in the beauty and personal care industry, allowing them to claim credits for FICA (i.e., Social Security and Medicare) taxes paid on employee tips, similar to the benefit currently available to restaurants.
• Compliance and monitoring: Employers and self-employed individuals should conduct regular audits to ensure that their payroll system updates are functioning correctly (or self-tracking is correct) and that all reporting requirements are being met. Additionally, they should keep abreast of any further guidance or updates from the IRS or the Secretary of the Treasury regarding the implementation of these provisions.

As the IRS releases more information on tip taxing, Baker Tilly professionals will be ready. For now, stay tuned and subscribe to our tax communications for strategic insight delivered straight to your inbox. 

If you have questions on how the above may impact your tax situation, reach out to your Baker Tilly tax advisor. 

Note: All analysis and planning considerations are subject to the particular facts and circumstance of clients’ specific tax situation.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.