What's Happening?
The One Big Beautiful Bill Act (OBBBA) has introduced new federal deductions for qualified tips and overtime pay, effective from 2025 through 2028. These deductions aim to provide tax relief for workers and require employers to reassess their payroll, reporting, and compliance practices. The tip deduction applies to voluntary tips, capped at $25,000 annually, and begins to phase out at $150,000 of modified adjusted gross income (MAGI). The overtime deduction applies to the premium portion of overtime pay mandated by the Fair Labor Standards Act (FLSA), with a maximum deduction of $12,500 per year. Employers must accurately report qualified tips and overtime compensation on year-end tax forms, and the IRS will publish a list of qualifying occupations by October 2025.
Why It's Important?
These deductions represent significant changes in how employers manage wages, tips, and overtime, potentially widening the gap between tipped and non-tipped employees. Employers must update their payroll systems to comply with new reporting requirements, which could impact employee retention and fairness. The deductions also expand the FICA tip credit to beauty and spa services, requiring businesses in these industries to review compliance with tax and labor laws. Employers must establish clear policies and documentation practices to minimize audit exposure and take full advantage of the deductions.
What's Next?
Employers are advised to reassess tip-sharing arrangements, evaluate compensation practices, and update payroll systems to align with the new rules. They should consult with payroll vendors to make necessary adjustments and prepare for potential employee requests to shift from exempt to non-exempt status to benefit from tax-free overtime pay. California employers face unique challenges due to state-specific overtime rules, requiring dual-track systems to distinguish FLSA-qualifying overtime from state-mandated overtime.
Beyond the Headlines
The introduction of these deductions may lead to broader discussions on wage fairness and employee classification, particularly in high-wage jurisdictions. Employers must navigate complex compliance landscapes, especially in states like California, where wage laws exceed federal standards. Transparent communication with employees about deduction distinctions is crucial to manage expectations and ensure compliance.
