The One Big Beautiful Bill Act (OBBBA) (P.L. 119-21) introduced a temporary federal income tax exemption on tips and overtime. Here are four things to know about this exemption:

1. New deductions

The OBBBA establishes below-the-line deductions through 2028 for qualified tip and overtime (OT) income. Taxpayers may deduct up to $25,000 of qualified tip income and up to $12,500 of qualified OT income ($25,000 for joint filers). The deduction phases out for individuals whose modified adjusted gross income exceeds $150,000 ($300,000 for joint filers). Individuals must provide a work-eligible Social Security number and, if married, must file a joint federal tax return.

2. Who benefits?

According to final regulations published in April 2026, tip-eligible occupations include food and drink services, ride-share drivers, beauticians, and other service-based professions that “customarily and regularly” receive tips. Workers in Section 199A Specified Service Trades or Businesses, including industries such as healthcare, legal, and performing arts, are not eligible for the deduction. 

Tips must be voluntary, non-negotiated, and paid by the patron in cash or charged, or received through tip-sharing or tip-splitting arrangements. To be deductible, they must be reported on IRS-approved Forms W-2, Forms 1099-NEC, MISC, K, or Form 4137. 

Employer-mandated service charges, which include automatic additions to a customer’s bill based on party size, holidays, or time of day, don’t count as qualified tips. Additionally, tips received by managers or supervisors through a tip-sharing agreement do not qualify.

For OT deductions, employees must receive OT pay as defined by the Fair Labor Standards Act. In short, the additional pay must be for hours worked beyond 40 in a regular work week. The deduction only applies to the amount paid in excess of their regular hourly rate, meaning only the “half” portion of time and a half.

3. Deduction limitations

Federal employment taxes, along with possible state and local income and unemployment taxes, still apply to tip and OT earnings. Additionally, only a total annual amount of $25,000 (tips) or $12,500 (OT) per taxpayer can be deducted from federal income taxes through their Form 1040 individual income tax return. The availability of state tip and OT deductions varies.

4. Employers be aware

Despite the federal income tax deductions, tax withholding and reporting of all required taxes is still required. Additionally, qualified tips and OT wages must be separately reported on Forms W-2 (for employees), Forms 1099 (for non-employees) or Form 4137 (my workers). Employees may then claim eligible deduction(s) on their Form 1040. Note that states may or may not allow similar tip and OT deductions.

• Tax withholding: OT and tip income must still be reported via Forms 941/944, W-2, and/or 1099, and all regular withholding taxes must be withheld and paid to the IRS, states, and localities, as applicable. Workers use the tip and OT amounts reported on their Forms W-2 to claim the deduction(s) on their federal income tax return.
• Employer reporting: Employers should continue to withhold all regular employment taxes from their employees’ wages. Employers are required to track and properly report tip and OT earnings. Note that the payer’s Treasury Tipped Occupation Code is part of the required reporting beginning with tax year 2026.   
• Payroll system updates: Payroll and accounting systems may already track tips and OT wages for purposes other than tax, but new software mapping may also be required to capture the tips and OT wages for purposes of satisfying the deduction provision requirements.
• Transition period: The IRS offered reporting penalty relief for tax year 2025. Guidance regarding this relief can be found in Notice 2025-62. Note that this penalty relief applies only to the extent that the information otherwise reported on Form W-2 or 1099 is complete and accurate.
• Tip credit: The new tip legislation broadens the tax credit to include employers in the beauty and personal care industry, allowing them to claim credits for FICA taxes paid on employee tips.
• Compliance and monitoring: Businesses and self-employed individuals should conduct regular audits to ensure that their record-keeping and tracking systems function correctly and that all reporting requirements are met.

If you have questions on how the above may impact your tax situation, subscribe to our tax communications or reach out to your Baker Tilly tax advisor. 

Baker Tilly is a leading assurance, tax and advisory firm. | Andrew Whitehair, Zev Weinstein, and Krissa Lietz, Baker Tilly

Note: All analysis and planning considerations are subject to the particular facts and circumstance of clients’ specific tax situation.