New No Tax Rules for Tips & Overtime: What Employers Must Know NOW

Speaker A: Ladies and gentlemen, welcome to the People Processes podcast. Today we're doing a special episode on HR1, the Big Beautiful bill which passed over the weekend. Spent some time reading it through and I've distilled out the key pieces that employers need to know about the no tax on tips and no tax on overtime provisions that have been passed and signed into law. HR1 establishes an above the line deduction for qualified tips and qualified overtime compensation. Both deductions take effect for the 2025 tax year and are set to expire after the 2028 tax year. The, uh, four years, 25, 26, 27 and 28. While these provisions are going to be very popular with employees, the new deductions bring their own set of challenges for employers and the calculations. So we're going to go through some of this key stuff, highlights and then some of the places that we're going to need some more clarification on. So July 3, 2025, the US House of Representatives passed that HR1, the one big beautiful bill act, uh, which was just a dramatic crazy journey through Congress and it was signed into law on July 4th. We're going to talk first about tips, because they're actually the easier of the two, and then we'll talk about overtime. So section 70201 of the act establishes a new above the line deduction for qualified tips. Above the line means it comes right out before AGI. Uh, it's a full income tax deduction. It's like you didn't make that money. In terms of federal income tax. The following conditions are what's going to catch people up and is important to remember. The deduction is capped at $25,000 per year and that amount is reduced by $100 for each 1,000 by which the taxpayer's adjusted gross income exceeds $150,000 $300,000 in the case of a joint return. Okay, so it's up to $25,000 a year. That's still great. Have no taxes or no income tax on those tips. Here are some of the more detailed parts. To be considered a qualified tip, the amount must be paid voluntarily without any consequence in the event of non payment, not be the subject of negotiation and be determined by the payor. Thus, for example, a mandatory service charge imposed by the employer for a banquet will not qualify for the deduction and neither will a required gratuity at a restaurant that adds automatically to bill. For larger parties, failing to make this distinction will lead to employees to claim deductions to which they are not entitled and would be highly problematic. So it is likely we're going to need to develop mandatory tipping versus non mandatory tipping or something along those lines in your systems to track them. Or of course don't charge people large group tips automatically, but I don't think that's going to be appropriate. More than likely we're going to need to veri. We're going to need to put it in place a system where that's automatically, uh, you know, said that we put it on there. You pay taxes or not on there, you don't pay taxes up to 25,000. The deduction applies to cash tips only. But that act broadly defines cash to include tips in cash or charged, as well as tips received by employees under a tip sharing arrangement. Uh, the definition exclude tips that are non cash, such as items like a gift basket or movie tickets. To qualify for the deduction, the tips must be received by an individual engaged in occupations that customarily and regularly receive tips on or before December 31, 2024. This is about design, uh, you know, deterring employers outside of the hospitality and service industries from recharacterizing a portion of their employees existing incomes as tips. In an attempt to take advantage of the new deduction, the act requires the Treasury Secretary within 90 days to publish a list of all qualifying occupations. I don't know if you've ever tipped your plumber. Right. But it's probably not a common practice. Okay, so they're not going to allow them to introduce a bunch of new tipped people. Uh, there's also some other key exclusions on there. Um, a tip does not qualify for deductions at all if it was received for services in the field of health law, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services in any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or that consists in investing or investment strategy, trading or dealing in securities, partnerships or commodities. You can't tip me for selling your business for $30 million. Just tip me 3 million. It's not going to work that way. Okay. Finally, employer requirement. The qualified tips have to be reported on statements furnished to the individual as required in the various provisions of the IRS code. Uh, basically issued on a form W2, uh, or otherwise reported by the taxpayer on form 4137. That's the Social Security and medicare tax on unreported tip. And come if they're doing their own, like if they're receiving tips and reporting it Themselves, employees and employers have long been required to report 100% of all tips to the IRS, including tips received in cash via charge on credit, uh, or through a tip sharing arrangement. And the act does not change that reporting requirement. It remains to be seen whether the act is going to encourage TIP employees to more readily report those tips paid in cash, considering that such reported tips may still be subject to state and local taxation and of course Social Security and Medicare. But we're hoping that it does make that those cash tip reporting is more accurate. The key is we're going to need to start differentiating likely between mandatory and non mandatory tips. Um, finally, if you're an ah, individual business owner watching this, and if you're in the case of qualified tips received by an individual engaged in their own trade or business, not as an employee, the deduction cannot exceed your, your gross income from such trade or business. Okay, so if you made $25,000 in tips and spent 10,000 to get them, so you only made 15,000, you can't call, you can't pull out 25,000 in a tax deduction. Uh, so you got to include on your W2 the amount of cash tips reported by the employee as well as the employee's qualifying occupation is a new thing for 2025. The Axe authorizes the reporting party to approximate the amount designated as cash tips pursuant to a reasonable method to be specified by the Treasury Secretary. We don't know what that is yet. A lot of people haven't tracked this perfectly well up till now. They're going to allow approximation on there and the W2 will have to be updated to include occupation. So if you don't have occupation in your systems, uh, your payroll systems that would go onto a W2, you're going to need to get that updated. There's a bunch of kind of additional stuff in there about tips. Uh, it requires the Secretary to establish other requirements to qualify for deduction before those set forth in the act. So if the Secretary needs to do something else to prevent fraud, they can, uh, to put together regulations and provide guidance to prevent reclassification of income as qualified tips and to otherwise prevent abuse. This no tax on tips deduction takes effect for the 2025 tax year it's in effect. Okay. That's what's important to know where it's July, half the year is gone. You haven't been tracking this stuff appropriately up till now. You got a bit of a problem. Now, tips I'm not super worried about because, well, people, employers are going to have a Couple things to consider from tracking perspective, but throughout the year they've done pretty well already on tracking tips. Employers may also be considering revamping their tip pool arrangements, encouraging customers to tip even in scenarios when tippings was not customary or otherwise expanding their reliance on tips, uh, to get more tip income to the pocket of their employees. There are strong rules regarding who may participate in a tip pool and they're strict. And failing to comply with them can prove very costly. So look at your tip pool laws. You can't, for example, tip pool, the owner of the company or senior management, presidents, a lot of stuff. And it varies by state. So don't just try to start shifting income to tips without really understanding this. Let some crazy people try that stuff out for a year or two before you do, if you can. Right. Let someone else get hit with it. Um, until they actually put out the rules and provide regulations on this, you should tread very carefully. All right, we're halfway through. Put a little marker, uh, here. So 70202. This is the section of the, uh, the, the Big Beautiful Bill. The One Big Beautiful Bill act creates an above the line tax deduction for qualified overtime compensation. Now this one is a bit more in the weeds and important to understand and it's where a lot of people are going to mess up. Pay attention. Qualified overtime compensation is defined as overtime compensation paid to an individual required under Section 7 of the FLSA of 1938 Fair Labor Standards act that is in excess of the regular rate at which such individual is employed. So what does that mean? A couple things. We're going to go through some of the conditions, but I think it'll help you understand. The deduction is capped at $12,500 per year. 25,000 in the case of a joint return in uh, for any filer. Okay, so if your husband can do $25,000 in overtime and you do zero, cool. You get to claim the whole 25. Right. 12,500 per person. The amount is reduced by a hundred dollars for each thousand by which the taxpayer's modified, uh, adjusted gross income exceeds 150,000 300,000 in the case of a joint return, just like before. So it's only for those who make less than 150 or 300 and it only allows you to do up to 12,500. This is the part you got to understand. The deduction applies only to overtime compensation that is required under the FLSA and only the amount that is in excess of the employee's regular rate. It does not apply to overtime premiums that are required, um, that are not required by the FLSA, but are paid pursuant to a contract, including collective bargaining agreements, or because they are required under state law, California law requiring daily overtime, for example, not exempt. Federal government wants its money. Only under the overtime that the federal government has laid out under the Fair Labor Standards Act 1938, does this apply. Okay, this is a big deal. This is an attempt to. You can't double dip on these deductions. The act clarifies that qualified tips, by the way, cannot be claimed as qualified overtime. Um, and that's really the key part here is understanding it. So just like in the tips we needed to figure out mandatory versus non mandatory tips, we now need to talk about federal overtime. State over federal overtime. And then the other stuff, whether that's state collective bargaining, shift differential, whatever, because they're going to be taxed at a different rate on the first $12,500. So, uh, not only is it that the, the critical point is it's not the amount paid in overtime, it's not the amount for the 41st hour in a week. It's the premium, it's the excess over the regular rate. Okay, so, um, let's say you make 20 bucks an hour. We're gonna do quick Math. You work 40 hours a week. That gets you 800 bucks. Okay, um, you work 50 hours a week. That's 10 hours of overtime. That 10 hours is not paid at $20 an hour, but instead $30 an hour. So on that 10, you made 200 in regular earnings and 100 in overtime premium, you went from 800 not to 1000, but to 1100 only. That extra hundred, that is going to be tax free. The regular rate is the same. So you have to go. This is going to be a big, you know, piece on here. Um, you're, we're going to, you're going to, you're going to have to change how you track this stuff. If you're in a system right now, if you work with us, a lot of our clients are this way we can, we'll get this changed up for them. But most payroll systems, it's going to say overtime is 30 bucks an hour, regular is 20 bucks an hour. And it's going to put all 30 bucks in overtime. It needs to put the $20 in regular and just the 10 in overtime. That's what has to, uh, start being reported on the W2, the overtime premium related to federal overtime. Now you're also going to need to track state overtime collective bargaining agreement Overtime, daily shift differentials, you know, overnight shift premiums, whatever. Those have got to be tracked separately. And when they conflict, you pay the federal overtime because that's tax advantaged. Uh, okay. It's going to be a little complicated. You're going to figure out some really strong pay calculation rules. Basically that step one is pay if it's over 40 hours in a work week, that gets paid as federal overtime. And then everything else goes below that on a separate line. Okay. That's a pretty big deal. Uh, a couple of other, um, pieces on there. Both the tax on tips and the no tax on overtime, um, is not allowed unless the taxpayer includes their Social Security number, um, on their tax return. Which, you know, I always thought that was required all the way anyway, but it turns out that's special. You can file your taxes without a Social Security number. Ah. So this one does in fact require a Social Security number. So that's interesting. We'll see if that gets challenged. Uh, I don't think it applies to a tax ID number. Yeah. Okay. The no tax on tips and no tax on overtime provisions are going to be popular with employees and we're very excited for them, especially those in the hospitality and service industry that depend a lot on tips for their income. These new deductions are going to bring their own set of challenges for employers. It's important that you not get too fancy with this for a little while. Going to be about tracking, adjusting, getting that set up. For now, um, employers may be considering converting certain salaried exempt employees to hourly non exempt status and paying them at an artificially low rate with the rest of their weekly earnings designated as overtime. That is wild. Okay. Um, it's very unlikely to succeed, um, that an employee classified as non exempt under the flsa, you have to keep an accurate record of all hours worked by the employee, calculate overtime based on actual hours worked. And you can't keep a record of a fictitious number of overtime hours to generate total weekly wages equal to the formal salary. Like, I know I'm going to get these questions. It's not the time to convert people off salary to hourly so they can get tax free overtime. 2. For those who are hourly, employers may consider reducing their hourly rate and pushing more of their earnings into overtime compensation. Right, by trying to trigger overtime at 30 hours or by paying double time for hours over 40. There was a lot of talk of this. This only applies to the required overtime premium from the flsa. Doesn't matter what you say is overtime only. What the FLSA says is overtime. That's going to be over 40 hours in a single work week. All right? You can't just designate stuff over time by a creative employer. Wanted to give those little heads up. I hope this was helpful to you. My name is Rami Alijal. I'm the CEO of People Processes. We're an HR company that does, uh, everything from recruiting through retirement across the entire United States, uh, for thousands, uh, of employees. And I'd love to help you out. Down below, you'll find a quick guide on what you need to know about this. Uh, you can share it with your team. You can, uh, book some time with me. If you're a US employer, over 10 employees, and you have any questions or would like a question, console and subscribe. Like, give us a comment. Let me know how you're doing. I'd love to hear from you. Thanks for taking the time.