Proposals to reduce taxes on tips and overtime, which passed the U.S. House of Representatives on May 22 as part of the One Big Beautiful Bill Act, would affect employers’ reporting requirements and could necessitate updated payroll systems. The proposals would take effect retroactively, starting at the beginning of 2025 and expiring at the end of 2028.
Although the proposals are subject to change as the Senate considers the legislation, employers that understand the House-approved proposals can consider the implications related to wage eligibility, reporting requirements and payroll administration.
No tax on tips
The tips proposal, titled “No tax on tips,” is not limited to tips received solely by employees (nonemployees can also receive the benefit), but it does present unique considerations for employers.
It would allow certain taxpayers to deduct cash tips, including those received by check or credit card, from their income. Eligible taxpayers would generally be those earning below the IRS’s threshold for “highly compensated employees” ($160,000 for 2025) working in customarily tipped occupations, as identified by the Secretary of the Treasury.
Taxpayers—both itemizers and those taking the standard deduction—would deduct tips on their own individual federal income tax returns, resulting in tipped income being exempt from federal income tax. Social Security and Medicare taxes would still apply.
What would this mean for employers?
- Tips would still have to be reported. As applicable, tips must still be reported by employees to their employers and reported by employers to their employees on Form W-2, Wage and Tax Statement.
- Tax withholding would still be required. The tips proposal does not create an exclusion from income subject to withholding. Tips would remain subject to federal income tax withholding (and state and local tax withholding where applicable), as well as employment tax withholding, including Social Security and Medicare taxes.
- Payroll systems and information may need to be updated. If passed in 2025, there may be a transition period during which payroll systems may need to be configured to reflect updated withholding tables or updated Forms W-4, Employee’s Withholding Certificate, received in anticipation of reducing taxable income for tips. However, while the “No tax on tips” rule would be effective beginning Jan. 1, 2025, the benefit would be claimed on a taxpayer’s individual income tax return, thus retroactive systems modifications are unlikely to be mandated.
- Form W-2 reporting would likely change only minimally. Tips are currently reported on Form W-2 as follows:
- Box 1: Wages, tips, and other compensation
- Box 5: Medicare wages and tips
- Box 7: Social Security tips (summed with Box 3, these numbers should not exceed the Social Security wage base ($176,100 for 2025))
- Box 8: Allocated tips from large food or beverage establishments
Under the House-approved proposal, employers would be required to separately identify total tips reported by employees on Form W-2. Employers already report most tips separately on their employment tax information return (typically Form 941, Employer Quarterly Federal Tax Return Lines 5b (Social Security tips)).
- Service charges, nonemployees and reporting implications. Keep in mind that service charges, such as an 18% automatic gratuity for large parties at restaurants, are not tips. Tips that are not reported by employees to their employer may still be deductible if employees report them on and file Form 4137. For nonemployees receiving tips, there is currently no specific reporting line for tips on Form 1099-NEC, Nonemployee Compensation (and some employers may not have much information about tips paid to self-employed individuals). However, the proposal would require 1099 reporting of tipped amounts and whether they are received in a customarily tipped occupation.
No tax on overtime
The overtime proposal, titled “No tax on overtime,” is limited to overtime wages paid by employers since only employers can pay overtime. The proposal would allow certain employees who, similar to those described above, are not highly compensated employees, to take a deduction for overtime wages paid pursuant to the Fair Labor Standards Act of 1938 (FLSA) and reported on Form W-2.
Similar to the tips proposal, employees would be permitted to deduct overtime wage payments from their income on their individual federal income tax return, thereby exempting them from federal income tax. Social Security and Medicare taxes would still apply.
Currently, overtime pay is not identified separately from regular wages on Form 941 or Form W-2. Similar to tips, the new law would require separate reporting on Form W-2 of total overtime wages paid.
What would this mean for employers?
- Tax withholding and reporting of employee compensation would still be required. As with the tips proposal, the overtime proposal does not create an exclusion from income subject to withholding. Overtime wages would still be reported to employees on Form W-2. Overtime wages would continue to be subject to federal income tax withholding (and state and local tax withholding where applicable), as well as employment tax withholding, including Social Security and Medicare.
- Payroll systems may need to be updated. Payroll systems likely already track overtime wages for purposes other than tax, but new software mapping may be required to also capture overtime wages for purposes of satisfying the requirements of the overtime proposal. Typically, vendors require time to bring systems up to date and, given that the provision would be retroactive to the beginning of 2025, this could present a transition period with administrative complexities.
- Overtime wages would need to be identified on Form W-2. Employers would be required to report overtime wages separately on Form W-2. This could be accomplished through a new Box 12 code or using Box14 reporting. It is unlikely that reporting on Form W-2, Boxes 1, 3, and 5 would change.
Other considerations
- Interaction with federal labor laws. The FLSA regulates employment practices for employees that are classified as “nonexempt,” including the payment of wages and overtime. The “No tax on overtime” proposal relies on section 7 of FLSA to define overtime compensation that may be deductible under the proposal; employers will need to navigate relevant federal labor laws along with the federal tax laws.
- State and local impacts. The proposals address only the federal income tax treatment of tips and overtime; there would be no change to state and local income taxation of tipped or overtime wages as a result of this legislation. State overtime laws may be different from federal, and understanding how they interact will be important for employers implementing these rules.
- The changes are temporary. The proposals are for calendar years 2025 through 2028; employers will need to consider the impact of the sunset.
- Employee communications. Employers may want to consider employee education on the proposals and communicating what changes, if any, employees can anticipate.
- Staying competitive. With recent inflation, spending power has declined, including for individuals that may benefit from the proposals. Employers with large groups of employees that earn tipped or overtime wages may want to ensure that payroll practices are up to date in order to comply with requirements and facilitate uptake by employees. Supporting eligible employees in their ability to use these benefits may help employers stay competitive in the marketplace and promote employee attraction and retention. Employers should consult with legal counsel and other appropriate professional advisors if they are considering making any changes to their employment or payroll practices.
