New Federal Tax Deductions for Tips and Overtime

New Federal Overtime Deduction Creates Immediate Payroll Compliance Risk — Especially in California

The One, Big, Beautiful Bill Act (“OBBBA”), signed into law on July 4, 2025, introduced two significant new federal income tax deductions: one for “qualified tips” under new Section 224 of the Internal Revenue Code, and another for “qualified overtime compensation” under new Section 225. Both deductions are available for tax years 2025 through 2028 and apply to itemizing and non-itemizing taxpayers alike.

While these deductions are claimed by individual workers on their personal tax returns, they create substantial new obligations and practical challenges for employers, particularly those operating in states like California, where overtime rules diverge significantly from federal overtime law. This post provides an overview of both deductions, with a focus on the overtime provisions and the specific complications they present for employers in states like California, where the overtime rules differ from the federal rules.

Brief Discussion of the Qualified Tips Deduction

Before the OBBBA, tips were treated like any other wages. If an employee earned $40,000 in wages and $10,000 in tips, the full $50,000 was reported in Box 1 of Form W-2 and subject to federal income tax. Box 7 separately reported Social Security tips, but there was no income tax deduction tied to tip income.

New Internal Revenue Code § 224 now allows eligible workers to deduct up to $25,000 per year in “qualified tips,” subject to income limits. The complication is reporting. The W-2 was not designed to distinguish “qualified tips” from “tip” in general. For 2025, the IRS permits reliance on existing fields (like Box 7, Form 4070 tip reports, or voluntary Box 14 disclosures). However, beginning in 2026, separate itemization of “qualified tips” will be required.

While employers with tipped workers should take note, the operational burden is far greater under the overtime deduction, which is where the more significant compliance challenges arise, and is discussed below.

The Qualified Overtime Deduction: How It Works

Under Section 225, individuals may now deduct “qualified overtime compensation,” which the statute defines as overtime compensation paid to the individual that is required under Section 7 of the Fair Labor Standards Act (29 U.S.C. § 207) and that is in excess of the regular rate at which the individual is employed. In plain terms, if a covered, non-exempt employee is paid time-and-a-half for overtime hours as the FLSA requires, only the premium portion (the “half” of time-and-a-half) qualifies for the deduction.

Key parameters of the deduction include:

• Maximum deduction: $12,500 per return ($25,000 for joint filers), with the benefit beginning to phase out at MAGI of $150,000 ($300,000 for joint filers).
• FLSA-required overtime only: Only overtime that is required under the FLSA qualifies. Overtime paid voluntarily by an employer, under a collective bargaining agreement, or required solely by state law does not qualify.

This last point (the limitation to FLSA-required overtime) is the source of the most significant complexity for employers in states with their own overtime rules.

The Critical Distinction: Only FLSA-Required Overtime Is Deductible

The statute draws a bright line: “qualified overtime compensation” includes only the overtime premium “required under 29 U.S.C. § 207” (the FLSA). Importantly, state mandated overtime is not included within this definition. IRS Notice 2025-69 makes the same point in practical terms: in situations where an employer pays overtime that is not required by the FLSA, while the additional one-half times portion required by the FLSA may be qualified overtime, payments in excess of the FLSA-required premium are not.

This means that when an employer pays overtime that exceeds what the FLSA requires (e.g. because of state law, company policy, or a union contract) the excess is not deductible. The employee must identify and segregate only the portion of their overtime premium that corresponds to the FLSA obligation.

Why California Employers Face Greater Complexity

This is where things get complicated. Several states, including most notably California, have overtime laws that are substantially broader than the FLSA in several critical respects:

Daily overtime. California requires overtime pay at 1.5 times the regular rate for all hours worked in excess of 8 in a single workday. The FLSA has no daily overtime requirement; it only requires overtime for hours worked in excess of 40 in a workweek. This means that a California employee who works a 10-hour day but only 38 hours in a week would receive 2 hours of overtime pay under California law, but zero hours of overtime under the FLSA. The overtime premium paid for those 2 hours would not be “qualified overtime compensation” for tax purposes and would not be deductible.

Double time. California requires employers to pay double the regular rate for all hours worked in excess of 12 in a single workday. The FLSA never requires double time. Even for hours that do trigger FLSA overtime (i.e., hours over 40 in a workweek), the FLSA only requires time-and-a-half. If an employee works a 14-hour day and 50 hours in the week, the double-time premium California requires for hours 13 and 14 exceeds what the FLSA demands. As IRS Notice 2025-69 explains, when an employer pays at a rate exceeding one-and-a-half times the regular rate, the qualified overtime compensation is limited to the portion of the overtime that is required by the FLSA that is in excess of the regular rate.

Seventh-day overtime. California requires overtime (1.5x for the first 8 hours, 2x thereafter) for work on the seventh consecutive day of a workweek. The FLSA does not require any special premium for seventh-day work as such; it only cares about total hours in the workweek exceeding 40.

Example 1: When Only State Overtime Applies

Consider Maria, a non-exempt employee in California earning $30/hour. In a given workweek, she works the following schedule:

• Monday: 10 hours
• Tuesday: 10 hours
• Wednesday: 10 hours
• Thursday: 9 hours
• Friday: off

Maria’s total hours for the week: 39.

Under California law, Maria is owed overtime for every hour she worked past 8 in a single day, regardless of her weekly total. That means:

Under the FLSA, Maria is owed no overtime premium at all. She worked only 39 hours in the workweek, which is below the 40-hour threshold. Because none of the overtime premium Maria received was required by the FLSA, the entire $105 is non-deductible under Section 225.

This is the core problem for California employees: an employee can receive substantial overtime pay under state law and have zero qualified overtime compensation for federal tax purposes.

Example 2: When State and Federal Overtime Overlap

The first example is straightforward: all overtime was California-only, and the FLSA deduction is zero. But the harder (and more common) case arises when an employee works enough total hours to trigger both California daily overtime and FLSA weekly overtime, with some California double time mixed in. In that scenario, the employer must parse the employee’s overtime pay into three categories: (1) the portion required by the FLSA and deductible, (2) the portion required only by California law and not deductible, and (3) the portion representing a California double-time premium that exceeds the FLSA rate and is also not deductible. Let’s walk through it.

Assume Maria earns $30/hour and works the following schedule:

• Monday: 13 hours
• Tuesday: 10 hours
• Wednesday: 10 hours
• Thursday: 10 hours
• Friday: 8 hours

Total hours for the week: 51.

Step 1: Calculate What California Requires

Under California Labor Code § 510, the employer owes overtime premiums on a daily basis, before considering weekly totals:

Day	Hours	Regular (≤8)	Daily OT at 1.5x (hours 9–12)	Double time at 2x (hours 12+)
Monday	13	8 hrs @ $30	4 hrs @ $45	1 hr @ $60
Tuesday	10	8 hrs @ $30	2 hrs @ $45	—
Wednesday	10	8 hrs @ $30	2 hrs @ $45	—
Thursday	10	8 hrs @ $30	2 hrs @ $45	—
Friday	8	8 hrs @ $30	—	—

California overtime premiums (the amount above the $30/hr regular rate):

• Daily OT hours (1.5x): 10 hours × $15 premium = $150
• Double-time hours (2x): 1 hour × $30 premium = $30

Total California overtime premium: $180.

This is the total amount above regular pay that California law requires the employer to pay. It is what a typical payroll system would record as “overtime pay.”

Step 2: Calculate What the FLSA Requires

The FLSA ignores daily hours entirely. It asks only: did the employee work more than 40 hours in the workweek? Maria worked 51 hours, so 11 hours are FLSA overtime at 1.5x her regular rate.

Step 3: Determine the Deductible Amount

The maximum amount of qualified overtime compensation Maria can claim as a deduction is the FLSA required overtime, which is $165. The remaining $15 of the $180 she received ($180 total California premium minus $165 FLSA-required premium) is a California-only premium and is not deductible.

The W-2 Reporting Challenge

This is where the rubber meets the road for employers. Starting in tax year 2026, Section 6051(a)(19) requires employers to separately report qualified overtime compensation on Form W-2. That means California employers must do something most payroll systems were never designed to do: for each pay period, distinguish between overtime premium dollars that satisfy the FLSA’s weekly 40-hour threshold and overtime premium dollars that are owed solely because of California’s daily overtime or double-time rules.

Most existing payroll systems track a single “overtime” category and do not make this distinction. This means California employers will likely need to come up with a payroll software work-around to enable parallel tracking and aggregating of overtime under these different sets of rules. That reconciliation must then carry through to the annual W-2.

The “Regular Rate” Complication

Under the FLSA (and state overtime laws), overtime is calculated based on the employee’s “regular rate,” not simply the employee’s base hourly wage. The regular rate is a legally defined term that generally includes all remuneration paid to the employee for employment, subject to specific statutory exclusions, and often results in a rate that differs from the employee’s stated hourly pay. That means nondiscretionary bonuses, commissions, shift differentials, and certain incentive payments must be included in the calculation. In the simplified example above, the base rate may be $30 per hour, but the regular rate for a given workweek may be higher once those additional forms of compensation are factored in.

This distinction directly affects the new deduction. “Qualified overtime compensation” is limited to the premium required under 29 U.S.C. § 207, which is the additional one-half of the regular rate owed for hours worked over 40 in a workweek. If the regular rate increases because of a bonus or other remuneration, the FLSA overtime premium increases as well.

For reporting purposes, this creates an added layer of complexity. Employers must not only identify which hours exceed 40 in a workweek but also ensure that the correct regular rate was used in calculating the FLSA premium. Beginning in 2026, the reportable amount is the FLSA-required premium based on the properly calculated regular rate, not simply the difference between an employee’s base rate and an overtime rate coded in payroll. Systems must therefore be able to compute the regular rate accurately and isolate the corresponding FLSA premium as a distinct annual figure.

Reporting Mechanics: 2025 Transition and 2026 Requirements

These deductions apply for tax year 2025, but the reporting infrastructure has not yet caught up. Forms W-2 and 1099 for 2025 have not been updated to separately report qualified tips or qualified overtime compensation, and the IRS has waived penalties for failing to do so this year.

Beginning with tax year 2026, that relief ends. Revised Forms W-2 will be published and will require separate reporting of these amounts. Employers must therefore have a reliable method in place to properly track the necessary data for year-end tax reporting.

Penalties for Non-Compliance

Beginning in 2026, failure to properly report qualified overtime compensation on Form W-2 may trigger steep penalties under Internal Revenue Code §§ 6721 and 6722. For 2026 filings, the penalty can be up to $630 per Form W-2. These penalties apply separately to the IRS filing and the employee copy, effectively doubling exposure. By way of example, a mid-sized company with 200 employees can incur over a quarter million-dollar penalty each year for this simple non-compliance.

What Employers Should Do Now

Given the complexity of these new requirements, employers, especially those operating in California and in other states with daily overtime or enhanced premium rules (Alaska, Colorado, and Nevada) should take the following steps now:

1. Audit your overtime practices. Identify which overtime payments are FLSA-required and which are required solely by state law, collective bargaining agreements, or company policy. In California, this means distinguishing daily overtime and double time from weekly FLSA overtime.
2. Consult your Attorney and payroll provider. Work with your attorney and payroll provider to confirm whether your payroll system can separately track FLSA-required overtime premiums. If not, begin working on a solution now. You will need this capability for 2026 reporting.
3. Prepare for employee questions. Develop internal resources or FAQs explaining the deduction, the distinction between FLSA and state overtime, and how employees can access the payroll information they need. Employees in California should understand that not all of their overtime premiums may be deductible, and Employers should be able to explain why.
4. Monitor IRS guidance. The IRS has indicated that Forms W-2 and 1099 will be updated for tax year 2026 and that additional guidance is forthcoming. Employers should stay current with developments by monitoring IRS.gov and consulting with legal counsel.