While more guidance from the IRS will be forthcoming, there are two key provisions in the One Big Beautiful Bill Act (OBBB) that directly impact payroll processing: overtime pay & tips reporting.
The new law allows employees to deduct up to $12,500 of qualified overtime pay ($25,000 for joint filers) from their federal taxable income for tax years 2025 through 2028. While this is a benefit at the employee tax return level, there are several changes that will impact payroll systems & employers.
- No change to overtime calculation or tax withholding responsibilities: Overtime must still be calculated under the Fair Labor Standards Act. Federal, state and local income tax withholding remains in place; however, employees may see reduced tax liability at filing. Social Security and Medicare (FICA) taxes still apply to all overtime wages.
- New Tracking & Reporting Requirements: Payroll systems may need updates to separately track overtime pay eligible for the deduction. Form W-2 may require new fields (e.g., Box 12 or Box 14) to identify qualified overtime. The IRS is expected to issue further guidance on tracking and reporting “qualified overtime.”
- Employee Impact: Eligible employees may receive larger refunds or reduced tax bills. Employees might choose to adjust their W-4 to account for the new deduction.
The law also introduces a deduction of up to $25,000 in qualified tip income per taxpayer (subject to income limits), starting in tax year 2025.
What this means from a payroll standpoint:
- Tip Reporting Continues: Employees must continue to report all cash and electronic tips. Tips remain part of total taxable wages and must be processed as usual.
- Federal Tax Deduction – Employee Level Only: The deduction applies when employees file their personal federal tax returns. It does not change withholding requirements during the year. Employees may opt to adjust their W-4 for lower withholding based on the anticipated deduction.
- No Changes to FICA Rules: Tips remain subject to Social Security and Medicare taxes. Uncollected FICA (due to insufficient regular wages) will still be reported on the W-2.
- W-2 Reporting Enhancements: Tip income may need to be separately reported under new IRS instructions to support deduction claims.
- Other Considerations: The deduction applies to federal taxes only—state and local taxes still apply. Only “qualified tips” (voluntary, customer-determined) count toward the deduction. The Treasury is expected to clarify eligible occupations and definitions.
In summary:
- Payroll services must continue to calculate and withhold overtime and tip income per FLSA and current tax laws.
- Federal deductions for overtime and tips do not impact withholding processes but will impact year-end reporting and system requirements.
- Stay tuned for further IRS and Treasury guidance.
If you have questions about the OBBBA’s impact on payroll at your company, please reach out to your SH&A representative for guidance.