What “No Tax on Overtime and Tips” May Mean for Small Business

And what to ask your tax pro—plus, how to find the best payroll solution for small businesses.

For small business owners, payroll changes don’t just affect paychecks—they may change how you track, report, and plan. One of the latest updates, part of the One Big Beautiful Bill Act (OBBA), introduces new rules regarding overtime pay and tipped income that could impact how individual income is taxed at the federal level.

Overview of the OBBBA Tax Deduction for Overtime and Tips

Under the OBBBA, certain types of overtime and tip income may now be deductible from an employee’s federal taxable income. These are individual income tax deductions, not payroll tax exclusions, so employers will still withhold Social Security and Medicare taxes as usual.  

While that might sound like a win for employees, small-business owners should also take note. These deductions could affect how you classify workers, track wages, report overtime and tips, and coordinate with payroll systems—especially if you employ hourly, tipped, or overtime-eligible staff.

This post breaks down what the “no tax on overtime and tips” provisions may mean, what to look for as an employer, and what to ask your tax or payroll professional as the Internal Revenue Service (IRS) continues to roll out guidance.

(Note: This article is for informational purposes only and should not be taken as tax or legal advice.)

IRS Guidance on Qualified Overtime and Tip Income

The OBBBA introduced two key income-tax deductions for workers, effective for tax years 2025 through 2028:

• No tax on qualified overtime compensation: Employees may deduct qualified overtime pay of up to $12,500 from their federal taxable income, effective January 1, 2025.

• No tax on qualified tips: Workers in eligible tipped occupations can deduct certain tips from their taxable income.

Both deductions were introduced to provide relief to working Americans and boost take-home pay in industries where extra hours or tipping are common.

The IRS issued guidance in September 2025 on the nearly 70 occupations and types of pay that may qualify for the no tax on tips deductions.  

In short, overtime and tips aren’t “tax-free” in the payroll sense—employers must still withhold Social Security and Medicare taxes, and employees may still see those payroll tax deductions on their paychecks. Instead, the tax relief will likely occur when employees file their individual tax return with the IRS, reducing taxable income for those who qualify.

What Small Business Owners Need to Know

For many small-business owners, these changes won’t immediately alter your payroll tax obligations—but they could affect how you track, classify, and report wages.  

Restaurants, salons, home service providers, and other small employers with tipped or hourly staff may want to take time to ensure their payroll systems can distinguish between “regular” pay and qualifying overtime or tips.

That means now could be a good time to review your payroll setup, double-check job classifications, and make sure you're set up to track tips and overtime pay for future reporting accurately. Doing this now could help employees claim deductions and reduce the risk of IRS scrutiny.

Understanding “Qualified” Overtime and Tips

The OBBBA’s definitions of “qualified” wages will be key for compliance.

• Qualified overtime refers to the premium portion of paid for hours worked beyond the standard 40-hour workweek, as defined under the Fair Labor Standards Act (FLSA).

• Qualified tips apply to occupations the IRS recognizes as “customarily and regularly” receiving tips, such as servers, bartenders, stylists, and certain hospitality staff.

Employers will need to track these categories carefully to ensure accuracy when reporting wages and preparing year-end forms like W-2s.

While the employee receives the deduction, employers are still responsible for reporting and documenting the amounts correctly. Misclassifying wages could cause reporting errors, and those mistakes could carry penalties.

How Payroll Systems May Need to Adapt

Even though this new rule targets individual income tax, it places more responsibility on employers to capture accurate wage data.

If you use a payroll provider, check whether your system can:

• Identify and tag overtime pay that qualifies under federal definitions.

• Separate tipped income for reporting purposes.

• Provide the documentation you’ll need to verify totals at year-end.

The IRS has announced that formal guidance is still in progress. For tax year 2025, employers are not required to separately report qualified tips or qualified overtime compensation paid on W-2s.  

The IRS plans to update Form W-2 in 2026 to include new codes: TT for qualified overtime and TP for qualified tips. For 2025, employers may use Box 14 or provide separate statements to help employees claim deductions. You can see a draft of the new W-2 form here.  

Until then, continue tracking overtime and tips—but keep detailed records and stay ready to adjust once payroll systems update.

Talking Points for Your Tax Professional

You don’t need to have all the answers, but it's helpful to know what kind of questions to ask.

When meeting with your tax professional or accountant, consider discussing:

• Eligibility: Which of my employees could qualify for the overtime or tip tax deductions under the new law?

• Recordkeeping: What payroll records or reports will help verify these amounts?

• Software updates: Will my current payroll system need changes to reflect new classifications?

• State implications: Will my state recognize these deductions, or will separate reporting be required?

• Timing: How will this impact my quarterly filings or year-end processes?

These conversations can help you ensure your payroll stays on track as guidance evolves.

Communicating the Change to Employees

While the employer’s main role is reporting accuracy, employees may have questions when they hear about “no tax on overtime or tips.”

It may be helpful to explain:

• The change affects federal income tax deductions that employees may claim when filing their personal tax returns. It does not alter paycheck withholding or increase take-home pay immediately.

• Employees will still see regular payroll deductions for Social Security and Medicare.

• The potential deduction will apply when they file federal tax returns, not necessarily on every paycheck.

You may also consider reminding employees to:  

• Review and update their Form W-4, which employers refer to determine federal income tax withholding.

• Keep track of their tips and overtime hours, since accurate documentation will support their individual tax filings.

Common Mistakes to Avoid Under the OBBBA

Because this is a new and nuanced area of tax law, small business owners should try to stay informed and consult with their professional tax or financial advisor.

• Misclassifying workers: Misclassifying workers could result in fines, penalties, and back taxes.

• Misclassifying pay: Not all overtime or gratuities count as “qualified.” For example, mandatory service charges, such as banquet fees, may not qualify as tips under IRS rules.

• Ignoring state differences: State and local tax agencies may not mirror the federal deduction.

• Overlooking documentation: If audited, you’ll need to show how your business calculated and tracked qualifying wages.

It’s also important to note that these deductions are temporary. They are set to expire after December 31, 2028, unless renewed by Congress. That means systems you adjust now should be flexible enough to roll back if the provisions sunset

Prepare Your Business for Year-End and 2026 Reporting

Here are a few practical steps small-business owners might consider taking:

1. Audit your payroll categories. Review how your payroll software classifies overtime and tips.  

2. Update employee records. Keep job titles, pay types, and classification data current.

3. Review your time tracking. Ensure your method for recording hours worked is consistent and accurate.

4. Engage your payroll provider. Ask whether updates are planned to accommodate OBBBA-related reporting.

5. Document all relevant wage data. Retain records of tips, overtime, and related pay calculations in case of future questions or audits.

6. Educate your team. Make sure managers and employees understand what’s changing and where to direct questions.

By acting now, small businesses can prepare for year-end reporting and get a start on the new year.

What Stays the Same in Payroll Compliance

Despite the new deductions, this law doesn’t overhaul every aspect of payroll. Payroll compliance means you must follow all federal, state, and local regulations that govern how employees are paid. Businesses that violate payroll regulations could face penalties and fines, which could hurt their bottom line.

As an employer, you’ll still need to:

• Withhold Social Security and Medicare taxes on all wages, including overtime and tips.

• Follow state and local tax laws, which may differ from federal rules.

• File quarterly returns and issue W-2s as usual.

In short, the core mechanics of payroll remain the same, but the data you collect and report may become more detailed.

Key Takeaways for Small-Business Owners

• The OBBBA’s “no tax on overtime and tips” provision offers employees potential income tax deductions. It also adds new reporting requirements for employers.

• Employers remain responsible for accurate classification, recordkeeping, reporting, and timely updates to payroll systems.

• Guidance is still evolving. IRS Notice 2025-62 confirms that updated W-2 reporting codes are expected in 2026. Staying connected with your payroll provider and tax professional can help you maintain compliance as new instructions are released.

• This change won’t reduce your payroll tax obligations.

Quick Summary: What Small Business Employers Should Know About “No Tax on Overtime and Tips” Requirements  

What Is It?

• Temporary federal income tax deductions for employees under OBBBA.

• Applies to tax years 2025–2028.

What Changed?

• Deduction for premium portion of overtime pay.

• Deduction for qualified tips (up to $25,000).  

What Employers Need to Do

• Continue withholding FICA taxes and paying payroll taxes.

• Track qualified pay types separately.

• Watch for IRS Form W-2 updates.

Key Terms

• Qualified Overtime: Premium portion of overtime under FLSA.

• Qualified Tips: Voluntary tips in IRS-recognized roles.

• Mandatory service charges do not qualify.

What’s Next?

• Keep updated with IRS guidance.

• Stay flexible and consult your tax professional.

How Online Payroll Solutions Can Help

SurePayroll By Paychex can help you simplify tracking, reporting, and managing payroll for hourly and tipped employees—so you can stay focused on running your business, not decoding tax law.

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