IRS Releases Guidance on Tip and Overtime Deductions

January 28, 2026

In Summary

The OBBBA introduces temporary federal income tax deductions (2025–2028) for qualified tips and the “premium” portion of overtime pay, both subject to a $25,000 annual cap and MAGI-based phaseouts. While the tip deduction applies to 68 specific occupations and excludes automatic gratuities, the overtime deduction is strictly limited to the extra “half” in time-and-a-half pay required by FLSA rules.
2025 Transition Year Reporting Protocols: Under IRS Notice 2025-62 and Notice 2025-69, 2025 is designated as a transition year where employers are not mandated to separately report these amounts on Form W-2. Consequently, workers and independent contractors are responsible for manually calculating their own qualifying deductions—using Box 7 of the W-2, Form 4070, or 1099-K records—and reporting them via the new Schedule 1-A (Form 1040).

The IRS has released guidance outlining how employers and workers should handle the new temporary deductions for tips and overtime compensation, available from 2025 through 2028 under the One Big Beautiful Bill Act (OBBBA). Two notices, issued in late 2025, explain how reporting will be treated during the 2025 transition year and what to expect in future years. The guidance also explains how workers can calculate and claim the deductions when qualifying amounts aren’t separately identified on year-end forms. To help clients, prospects, and others, Dermody, Burke & Brown, CPAs, has provided a summary of the key details below.

Overview of the Deductions

Qualified Tip Deduction — The deduction for qualified tips is available to workers in occupations where tipping is a customary and regular part of compensation. The Treasury has identified 68 qualifying occupations. Only voluntary tips qualify; automatic gratuities do not. The deduction is limited to $25,000 per year, regardless of filing status, with phaseouts beginning at $150,000 modified adjusted gross income (MAGI) for single filers and $300,000 for joint filers.

This is a federal income tax deduction only. It does not affect how tips are reported for FICA or state tax purposes. The deduction changes how eligible tip income is treated on the tax return but does not affect how tips are reported as income or withheld through payroll.

Certain professionals, including those in accounting, law, and consulting, are excluded under the specified service trade or business (SSTB) exception, similar to limitations under Section 199A. However, the IRS is reviewing this rule and will not enforce it for 2025.

Qualified Overtime — The deduction for qualified overtime compensation is limited to the overtime premium portion, which is generally the extra “half” in time-and-a-half required under the Fair Labor Standards Act (FLSA). It does not include the full overtime payment. Any amounts paid above the FLSA-required premium, such as bonus pay or contractual rates, are not part of the deduction.

The deduction is capped at $12,500 per year ($25,000 per year filing jointly), with the same MAGI phaseouts as the tip deduction. Eligibility depends on whether the worker is covered by federal overtime rules and whether the employer is subject to the FLSA.

IRS Guidance on Reporting and Claiming the Deductions

The IRS addressed implementation of these deductions through two notices.

Employers (Notice 2025-62) — For 2025, the IRS is treating this as a transition year. Employers are not required to update systems to separately report qualified tip or overtime amounts. However, employers are encouraged to help workers understand what information is provided on their year-end forms and what is not. Employers may choose to issue statements or include information in Box 14 of Form W-2 for convenience, but it is not mandatory for 2025. These changes are intended to give payroll providers and HR departments time to prepare for full implementation in 2026.

Workers (Notice 2025-69) — Employees and independent contractors must calculate the deductions if qualifying amounts are not listed separately on year-end forms.

For tips, W-2 workers can use the amount of Social Security tips reported in Box 7 of Form W-2 or the amount reported to employers on Form 4070. If an employer voluntarily includes tip amounts in Box 14 or a separate statement, that figure may also be used.

For independent contractors, qualified tips can be calculated using information reported on Forms 1099-NEC, 1099-MISC, or 1099-K, along with supporting records such as receipts or transaction summaries.

For overtime, workers must isolate the premium portion of overtime pay. The IRS has provided examples and formulas for doing this under FLSA rules.

Both deductions must be reported using the finalized Schedule 1-A (Form 1040). It is important to note, neither deduction is available to those that are married and file separately.

Next Steps

Employers – Employers should confirm what payroll systems can report for 2025 and begin updating systems for 2026. For the 2025 tax year only, employers may choose to provide additional context to workers who may qualify for either deduction. The IRS encourages employers to provide information to workers about what information is included on year-end forms and what is not. It may also be helpful to provide information to workers on how to claim the deductions during tax season.
Workers – Claiming either deduction should review their year-end tax forms, payroll records, and any other documentation. If qualifying amounts aren’t clearly identified, use the methods outlined by the IRS for calculating both deductions. To claim the deduction, the qualified amounts must be reported using Schedule 1-A by the tax deadline.

Contact Us

The IRS guidance explains how the new tip and overtime deductions will be applied in the first year. Employers are given flexibility on reporting, and workers are given instructions for claiming the deductions on 2025 tax returns. For 2026, new reporting guidelines will apply. If you have questions about the information outlined above or need assistance with another tax issue, Dermody, Burke & Brown, CPAs, can help. For additional information call 315-471-9171 or click here to contact us. We look forward to speaking with you soon.