No Tax on Tips & Overtime Explained: What Business Owners Actually Need to Know

Andy Gargana (00:00)

Most employees see no tax on tips, no tax on overtime. So they get their pay stub and they see FICA taxes and federal taxes came out of their tips. And right away they're on the phone to their employer or they're calling us saying, hey, wait a minute. This no tax on tips, why am I still paying tax on this?

Announcer (00:17)

Welcome to THRIVE, a Paychex Business Podcast. Your blueprint for navigating everything from people to policies to profits. And now your host, Gene Marks.

Gene Marks (00:27)

Hey, everybody, it's Gene Marks. And welcome back to another episode of the Paychex THRIVE podcast. We're really, really glad that you are joining us today. Before we get started, chances are, if you're a THRIVE listener, you already know that running a business takes passion and vision and a whole lot of work. We all know that. But no one said you have to do it all alone. Of course. Right? That's where Paychex comes in. From payroll to HR to employee benefits, they've got the tools and expertise to help you manage the day-to-day so you can focus on what truly matters, building your business and achieving your goals. So, you can see how Paychex can make a difference for you. You can get to know them better by going to paychex.com/MeetPaychex. That's P-A-Y-C-H-E-X.com/M E-E-T-P-A-Y-C-H-E-X. You can also find the link in the show notes, so check it out today. All right, let's get to the conversation at hand. I have got with me Andy Gargana, who is a Federal Compliance Analyst at Paychex. Andy, thank you so much for joining. I am glad that you are back on the podcast to share your wisdom.

Andy Gargana (01:34)

Yes. Thanks for having me, Gene. It's been a while. I think it was back, COVID Bill, I think last time we talked.

Gene Marks (01:41)

But today's topic is of high concern to a lot of business owners, payroll managers, HR managers as well. It's all what we need to know about the no tax on tips and the no tax on overtime provisions that were part of the Big, Beautiful Bill, the Tax and Spending Bill that was signed into law in early July. So as a business owner myself and also as a CPA, you got the knowledge, I'm going to, ask you some specific questions about no tax on tips and no tax on overtime, so we can really get the facts from you. Are you cool with that?

Andy Gargana (02:17)

That sounds good. Yeah.

Gene Marks (02:18)

Right. So let's do it. So first of all, let's just tee it up. What are the no tax on tips and no tax on overtime provisions and how do they work? Walk us through it.

Andy Gargana (02:29)

Well, the first thing, I guess most importantly, it's kind of a misnomer. Yes, no tax on tips, no tax on overtime sounded great on the campaign trail and everything. An employee is actually still paying taxes on these. They will have their FICA taken out their federal income tax on both their tips and their overtime. The no tax, if you will, part comes in when they file their individual tax return. So, we'll start with tips, for example. Any tipped employee can deduct qualified tips, which, how do you define qualified tips? IRS puts out there a qualified tip is in the business, a tip that's received in the business that customarily receives tips. So, you have servers, cosmetology industry, there's a whole bunch of them. We can get into it later, but IRS put out a listing of occupational codes which are eligible to take the tip deduction. So if your employee is one of those occupations, then they can take the tip deduction. What it is, is for tips, a tipped employee can take up to $25,000 deduction when they file their 1040. IRS released or updated some schedules on their 1040, which will allow the employee to claim this deduction. It phases out. I believe it's $150,000. If your income level hits $150,000, the deduction starts phasing out. I think it's a hundred dollars per thousand over $150,000. So obviously, if you make more, you're going to get less of a deduction on your tax return.

Gene Marks (04:01)

Okay.

Andy Gargana (04:02)

Overtime is a very similar thing. You're still going to pay your FICA on that. You're still going to pay your federal income taxes. And then that is unqualified overtime, which is defined by the FLSA standards. That's a mouthful. Which is standard federal time and a half for overtime. So the deduction is on the premium portion, which is the half of that time and a half. And that's the amount an employee can use to deduct on their 1040. Now, the overtime deduction is only up to $12,500. That also has the same income phase-out at $150,000. So, it's a little, overtime is a lot more complex in my opinion, just because you have a lot more state regulation. Certain states pay a lot more than time and a half. Certain employers just pay more than time and a half. But for the rule, the federal rule, you can only take the half premium portion of the overtime and deduct it.

Gene Marks (04:58)

Good. So let me sum up what you've told me so far. Right. So, this is not, when you talk about no tax on tips, on no tax on overtime, it's not immediate, it's a deduction that the individual is going to be taking. The employer really doesn't do anything other than report, which we're going to talk about shortly. But it's the individual's responsibility and their individual return to take if they're eligible to take a deduction for the tips they earned or take a deduction for the overtime that they earned. For the tips, there's limitations on income and it does start phasing out. And you also said that this still does not affect FICA taxes or Medicare, so we still have to pay those regardless. But it does affect our federal income taxes and also particularly with overtime. States might have different rules. Have I got that good so far?

Andy Gargana (05:47)

Correct? Yep. Yeah. It's not an immediate benefit, unfortunately. You will do just as you've been doing, paying taxes on tax on tips and overtime. You will get it back at the end of the year when you file your tax return.

Gene Marks (05:59)

Got it.

Andy Gargana (06:00)

The one important piece I forgot to mention is this is retroactive back to January 1, 2025.

Gene Marks (06:05)

Okay.

Andy Gargana (06:06)

So this is a deduction that employees will be able to take advantage of this coming April when they file the 1040 returns.

Gene Marks (06:12)

Perfect. Okay. So now I'm an employee and the year is over, 2025 is over. And you know, I need to know, like, I got tips. So, I want to take this deduction on my individual returner, or tell my accountant what it is, or I got paid overtime. And like you said, it's only the overtime differential. It's not the full overtime wage. It's that actual half of the time and the half. Right. So, I need to tell my accountant that, or I need to know that so I can do my tax return. So, the employer's got to tell the employees this. You know, they're going to have to report to the employees. So, talk to me about the reporting requirements for employers for 2025 and also what you see happening in 2026.

Andy Gargana (06:56)

Well, 2025 is kind of the Wild West.

Gene Marks (06:58)

Yeah.

Andy Gargana (06:59)

IRS put out guidance. It was believe Notice 2025-62, which offered transition relief to employers and employees for 2025 only. We'll just talk 2025 right here. Basically, saying if an employer and an employee make a reasonable attempt to get the correct amounts, IRS is not going to penalize. Now, reasonable is, take that word for what you will. I mean, obviously, if you report an astronomical amount in the year before, you had barely anything, that might draw a few red flags at IRS. But as long as you are making a reasonable attempt, using the information you have from your pay stubs, your tip reporting forms, to try and get a correct amount for that deduction, you should be okay for 2025. Now, 2026, which we don't have a lot of information yet, we're still waiting for guidance on IRS. They did put out, obviously, the 2025, because that is front of mind since it's coming up very shortly. 2026, they have a little bit of runway still to get that out before the end of the year. But they are going to be changing reporting requirements on the W2. So, this information will be a lot more accurate for 2026, 2027, and 2028 reporting, which is the other three years that these provisions are in effect. But, yeah, 2025, the IRS acknowledged that employers and employees were not tracking this information in the form that they needed it at the beginning of the year. So they know that the amounts are not going to be totally accurate. Obviously, with any tax return, you need to be as accurate as possible, and you want to verify your information and have information to back that up. So, if there ever was a question from IRS, you can say, well, here's what I use to determine this amount, and you should be okay for 2025.

Gene Marks (08:49)

How are you, how are you reporting this if you're an employer, though, Andy? I mean, will this be on the W2? Will it be some other form of documentation, some other type of communication? How will an employer, even with their best efforts to tell the employee what tip income they earned or what overtime they earned, how will they be doing this in 2025?

Andy Gargana (09:08)

In that transition guidance, basically IRS gave a free pass to employers for this year because they said there's no requirements for how an employer has to report it. Now, obviously, an employer is going to want to help out their employee. They're going to try and get them information on this, because if not, they're going to get a million calls saying, hey, how do I determine this? So anything they can provide is going to be helpful. IRS mentioned several methods. You can report it on box 14 of the W2, you can provide a separate statement to the employer saying, hey, here's your tips for the year, here's your overtime for the year based on the information we have in our system, or some other method the employer can come up to as a way to get that information to the employee.

Gene Marks (09:50)

Right. So really, if you're running a business where you have, you know, it's a service business, say you're running a coffee shop or, you know, a restaurant or whatever, you're going to have a bit of a headache this year. I mean, you're going to have to do a little legwork and figure out, you know, the tipped income for your employees, because they're going to be asking, you know what I mean? Obviously, they want to take this deduction, so you got to be ready to respond to them. So, I think that's something that employers need to know about and we need to get that message out. And that is, that's really helpful. Okay, let's move on to the next one. Some common misperceptions. You know what, what are some of the common misperceptions around these changes, both for employees and employers that you've seen?

Andy Gargana (10:36)

I think the biggest one is the one I mentioned right off the top, is most employees see no tax on tips, no tax on overtime. So they get their pay stub and they see FICA taxes and federal taxes came out of their tips. And right away they're on the phone to their employer or they're calling us saying, hey, wait a minute, this no tax on tips. Why am I still paying tax on this? So I think education is the biggest piece just for employees, so that they know, like, okay, yes, it says no tax on tips, no tax on overtime. You're still paying taxes on these. You're going to get money back at the end of the year as a deduction on your tax return. But you still have to pay tax, even though technically the title is no tax on tips, no tax on overtime. I think by far that's the biggest question we get from, from clients even saying, hey, all my employees are calling. Why are you still taking taxes out on this? So I think definitely that is the biggest misnomer right off the bat. Just understanding that it is a deduction at the end of the year. It is not an instant. No, you're not paying taxes on this.

Gene Marks (11:39)

Okay, all right, that's super helpful. You mentioned earlier about the limits, but let's revisit them one more time. Okay, let's start with tips. Say I'm a tipped employee. What... There's a different deduction you can take if you're filing individually or filing a joint tax return. And, you know, and these deductions start phasing out at a certain point. So, walk us through, just for tipped employees, what those numbers are.

Andy Gargana (12:05)

Yep. The tips is just a standard deduction, $25,000 that applies to both. So that's the max they can take for overtime. For an individual, it's $12,500. For a joint filer, it's actually doubled as $25,000. Again, both of them are subject to the income phaseout rules. When they hit the $150,000, then their deduction decreases by $100 per $1,000 over their gross income amount.

Gene Marks (12:30)

All right, great. So, it's $50,000 for joint filers, $25,000 for individual filers for tips. For overtime, it's $12,500 for individual and $25,000 if you're a joint filer. That's like the max that you can deduct. The income limits, where you, it starts, you can take less and less of this deduction, starts at $150,000 a year individually, correct?

Andy Gargana (12:57)

Correct.

Gene Marks (12:58)

Okay. And again, on the tip side of it, that deduction is taken after the end of the year, taken on your return, and it still would not include, you would still have to pay your FICA and your Medicare taxes. The same thing with overtime as well, correct?

Andy Gargana (13:17)

That is correct. Yep.

Gene Marks (13:18)

Good. Okay. That's great. Okay, let's talk about what Paychex could do for this. Now, you know, we, this is a Paychex podcast, so we can talk specifically about Paychex. But I do want to tell our listeners, even if you're not a Paychex customer or whatever, I mean, this is, what can your payroll service do for you? What could your, you know, HR, a good HR manager, what could they be doing? Tell me how you guys are preparing your clients for this as we head towards the end of the year.

Andy Gargana (13:47)

As I mentioned before, education. We've been hard at work for the past. When did this pass? July. So, six months, five months, six months. Just trying to get everything documented, trying to put all the little caveats of the law in there so clients and their employees know, like, okay, these are what these mean, these are how you're going to take them. As far as providing information, for 2025, Paychex is going to be putting the amounts in box 14 on the W2. So when the employees get their W2, there's going to be a notation in box 14 for tips and one for overtime. Just saying, okay, these are the amounts we have in our system. This is what was reported to us. Now, the important thing is the employees are going to need to verify that they can't just take that amount right off the W2 and throw it on the return and say, okay, here's my deduction. Because before July 4, when this was passed, this amount, these amounts weren't tracked as closely as they're going to be in the future, the deduction. So we can't guarantee the accuracy. We only are as good as the information we have. So it's going to be up to the employee to verify that. I mean, maybe they didn't report all their tips in the beginning of the year, so we might not have that information. So they're going to have to be vigilant and just check the records and make sure that they're qualifying for the maximum amount of deduction they can get.

Gene Marks (00:15:05)

So employees are not going to do that, though, Andy. Right? I mean, they're going to see the number on their W2, and they're just going to grab it and they're going to run with it. So, I mean, to me, it seems like it's the employers who have to, you know, even when they send their W2s to their employees, might want to, you know, inform them with the caveat that this number might, you know, you know, you may or may not be 100% correct and to verify it with them first before using it on their tax returns. Is that, is that something that you think your clients should be doing?

Andy Gargana (15:38)

Yes, we are going to be communicating that. Again, just like you said, we can communicate everything we want, but if we need the message to get through, just to tell them, like, look, here's the information. This is what we have. You need to verify this and make sure. Tell your employees they need to verify, because this is, again, we only can provide what we have in there. So, yeah, definitely, that is very important. It definitely needs to be looked at closely before the returns are filed, and employers can help with that.

Gene Marks (16:09)

Yeah, I think that's absolutely, that is absolutely correct. All right, so final question. You know, once we get through 2025, which obviously is a bit of a pain in the neck, and, you know, it's like you said, it's a Wild West out there right now, I'm assuming things are going to, you know, get a little bit more standardized. What can we look for in the future? How do you think this will work? And, oh, by the way, doesn't this expire in 2028?

Andy Gargana (16:33)

Yes, it does. That's the thing. We're going to get all the kinks worked out and have it running smoothly, and then it's going to expire. Yeah, of course, that's typical for federal legislation. So, yeah, definitely. I mean, again, we're going to need additional guidance from IRS. They've provided a lot and I want to give them kudos for dealing with a government shutdown. I mean, we badgered them all late summer and early fall. Hey, we need guidance. We need guidance. And then the government shutdown happened. We're like, oh, great, of course we're going to be in trouble. And I know a lot of those IOS Council people worked through the shutdown and got the guidance out to us. And actually, with the transition relief, we were very happy with the guidance we got. So, we definitely will need some more for 2026, because as I mentioned, 2025, there was no strict reporting requirements. Obviously you want to help your employees, but there's nothing codified that says you have to do it this way. Whereas 2026, they're going to add codes to the W2 for box 12, which are going to specifically outline tips, over time. And also, as I mentioned in the very beginning, the Occupational Code List, or TTOC, Treasury Tipped Occupation Code, I believe is what it stands for, there's a listing. I think it's 60 to 70 occupations which are eligible for the tipped credit or deduction. I don't want to get in the habit of saying credit for the tip deduction. And that's actually going to be required to be reported on the W2 as well.

Gene Marks (18:02)

Right.

Andy Gargana (18:02)

The 2026 W2, the draft is out there, and they actually split box 14 and put a separate box in 14B, I believe it is, where an employer needs to report that treasury occupation or tip occupation code on the W2. And I'm assuming that will be somewhere on the 1040, but I don't know that for sure. That's just a gap on my part. But, so that'll be definitely a new... Because there's no requirement for 2025 to report that code anywhere. So that'll definitely be a new requirement for 2026. And then the box 12 reporting for 2026 as well.

Gene Marks (18:39)

I got, I got another bit of warning, both the employers and their employees as well. If, you know, things are going to get a lot more refined next year, like you just said, if you report incorrect tips or overtime wages this year, you overstate the deduction, even if it's done innocently because you took the number off the, you know, off a form, it wasn't calculated correctly or whatever, and then next year it comes in significantly different, those are the kind of things that do catch the eye of the IRS as well. You know what I mean? So, you know, so it's important for us all to know that, like, oh, wow, I got a, you know, $25,000 deduction for tips this year, but then actually next year and I'm same job, same everything was like a $10,000 deduction. You know what I mean? Like, that raises eyebrows. So you really want to be careful. Try your best to get it as right as it can be for this year, because it will save you headaches in future years is what I guess is what my point is. Does that make sense?

Andy Gargana (19:38)

Absolutely. I agree wholeheartedly. It's just going to be vigilance on the part of the employees, which it stinks you have to throw it back on them. But ultimately, as with any tax return, the person filing that's the one who's going to be responsible if there's a problem for it, so you want to be as accurate as possible at all times. But yeah, it's 2025 is definitely a challenge just because this was not tracked adequately in the beginning of the year because there was no need to. And so now everyone's scrambling, trying to get the most accurate information they can. So, yeah.

Gene Marks (20:11)

All right. That's great. Andy, great information. I really appreciate it. I, you know, obviously you're going to be back with us in 2026 as we these things flesh itself out and there'll be more questions to be answered. But I really appreciate you spending the time.

Andy Gargana (20:23)

I appreciate you having me. We do this again in a year when the 2026 requirements are out.

Gene Marks (20:27)

Hopefully, before that. Hopefully, before that. Everyone I've been speaking to Andy Gargani. He's a federal compliance analyst at Paychex, and we have been discussing what you need to know about the no tax on tips and no tax on overtime roles, both from an employer and an employee standpoint. My name is Gene Marks, and you have been watching or listening to the Paychex THRIVE podcast. Remember, if you need any help or advice or tips in running your business, sign up for our Thrive newsletter. Go to paychex.com/Thrive and you can get all the information you need to help you run your business. Thank you so much for watching or listening. Hope you got some good information out of this one. I know I did. We will see you again next time. Take care. Do you have a topic or a guest that you would like to hear on THRIVE? Please let us know. Visit payx.me/ThriveTopics and send us your ideas or matters of interest. Also, if your business is looking to simplify your HR, payroll, benefits, or insurance services, see how Paychex can help. Visit the resource hub at paychex.com/worx. That's W-O-R-X. Paychex can help manage those complexities while you focus on all the ways you want your business to thrive. I'm your host, Gene Marks, and thanks for joining us.

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