What You Need to Know About Taxes on Tips and Overtime

Employees may have questions about the new tax deductions for qualified tips and qualified overtime created under the One Big Beautiful Bill Act (OBBBA), passed in July 2025. Below is a streamlined overview for employers and employees.

Key Takeaways

1. Payroll tax withholding has not changed. Tips and overtime remain taxable wages subject to federal and state income tax withholding, Social Security, and Medicare.
2. Form W-2 will not change for 2025. Employers are not required to report additional information related to these deductions until the 2026 tax year.
3. Employees are responsible for claiming the deductions. Employees must calculate and claim any eligible deductions on their individual 2025 income tax returns and should consult a certified tax professional with questions.
4. The IRS issued employee guidance on 11/21/2025, including examples to help employees calculate qualified tips and overtime for these deductions.

Pay Statements and Records

For employees paid by E3 for the full year, the final 2025 pay statement is a key resource when preparing their tax return. Pay statements are available:

1. to clients via Prism
2. to employees via the employee portal (UEX)

Employee registration and navigation guides are available to clients through ShareFile.

Employees who received pay from another employer in 2025 may need to perform additional calculations using records from those employers.

Employee Guidance: New 2025 Deductions

“No Tax on Tips” Deduction

Employees may be eligible for a deduction for tax years 2025 through 2028 if they received qualified tips and worked in an occupation identified by the IRS as typically receiving tips.

1. Tip Amounts: Employees may use one of the following reported amounts to calculate the deduction:
   • Cash tips (Box 14 of Form W-2)
   • Social Security tips (Box 7 of Form W-2)
   • Tips reported to the employer on Form 4070 (or a similar substitute)
   • The amount reported on Line 4 of Form 4137 filed with the 2025 tax return
2. Maximum Deduction: $25,000 annually, with phase-outs for adjusted gross income over $150,000 ($300,000 for joint filers).
3. Eligible Occupations: Employees must determine whether their occupation appears on the IRS’s proposed list of eligible tipped occupations.

“No Tax on Overtime” Deduction

This deduction applies only to the FLSA-required overtime premium, meaning the additional “half” portion of time-and-a-half pay for hours worked over 40 in a workweek.

1. Qualifying Overtime: Only the premium portion required by the Fair Labor Standards Act (FLSA) qualifies.
2. Non-Qualifying Overtime: Overtime paid beyond FLSA requirements does not qualify, including:
   • Daily overtime required by state law (Alaska, California, Colorado, Nevada)
   • Overtime paid under a more generous company policy (e.g., counting PTO as hours worked)
   • Overtime required by a collective bargaining agreement (CBA)
3. Using the Final 2025 E3 Pay Statement:
   • If overtime is paid strictly at 1.5x the regular rate, employees may use one-third of the reported “time and a half” amount to determine the qualifying premium.
   • If overtime is paid at a higher rate (e.g., double time), employees must use a reasonable method to isolate the FLSA-required premium (e.g., one-quarter of the double-time amount).

Guidance for E3 Clients

“No Tax on Tips”

1. Review workers’ compensation code assignments to ensure accuracy, as these codes will be used to identify eligible tipped occupations.
2. Ensure tips are reported separately from gratuities and service charges. Gratuities and service charges are not eligible for the deduction (e.g. 18% gratuity automatically added for large dining parties). The IRS has provided additional guidance on identifying qualified tips.

“No Tax on Overtime”

1. Maintain accurate systems for collecting and verifying hours worked, including documentation of days worked. If you do not currently use a timekeeping system, E3’s Client Support can help connect you with integrated vendor options.
2. Verify that employees are correctly classified as FLSA exempt or nonexempt. The U.S. Department of Labor’s Fact Sheet #17A provides classification guidance, and E3’s Payroll and Risk teams can assist with reports or code updates.
3. Review active worksite locations to determine whether state-based overtime rules apply.
4. For employees working in Alaska, California, Colorado, or Nevada, state-required daily overtime must be submitted separately from FLSA overtime. Use a unique pay code to indicate that the hours do not qualify as overtime under FLSA in the employee’s work state. E3’s available pay codes for this purpose are:
   • • AKDAYO/T (Alaska Daily Overtime),
     • CADAYO/T (California Daily Overtime),
     • CODAYO/T (Colorado Daily Overtime),
   • and NVDAYO/T (Nevada Daily Overtime).

Additional state-specific guidance is available in the attached FLSA vs. State Overtime reference guide.

1. You may need to modify payroll file submissions to include the calendar week-end date for each set of hours worked to support IRS transparency around overtime calculations. Please contact your Payroll Technician to coordinate any required changes.
2. Retroactive payments for hours or wages missed weeks prior must be submitted separately from your regularly scheduled payroll to ensure the correct week-end date is reported.
3. By default, E3’s overtime pay codes are intended to calculate 1.5x the employee’s regular rate. Please contact your Payroll Technician if you plan to use an alternative method for overtime reporting and processing as this will impact your year-end reports moving forward.

Final Notes on Tax Advice

These rules are complex, and neither employers nor E3 team members can provide tax advice. Employees should be encouraged to consult a certified tax professional to determine eligibility and properly claim any deductions on their 2025 tax return.

E3 will continue to monitor IRS guidance and expected tax form changes in early 2026 and will share updates as additional information becomes available.