Understanding the New Federal Tax Deductions for Tips and Overtime Pay in the Hospitality Industry

Daniel C. Conlon, dconlon@tuckerlaw.com, (412) 594-3951

The U.S. Congress’s passage of the One Big Beautiful Bill Act (H.R. 1 of 2025) introduced several new sections to the U.S. Tax Code aimed at reducing the tax burden on workers. For restaurants, hotels, and other service-based businesses, two changes stand out: the new deduction for tip income and the deduction for overtime pay. These tax deductions are retroactive to January 1, 2025, and will expire on December 31, 2028, unless extended.  

The new law presents compliance challenges for employers. Understanding how these deductions work is essential for restaurant owners, operators, and payroll managers.

The Tip Income Deduction

Employees who receive qualified tip income can deduct up to $25,000 per individual in a year from their taxable income. (Sec. 224). Qualified tips include cash tips, credit-card tips, and tips distributed through valid pooling arrangements, provided the payments are voluntary and determined by the customer.

The tip income tax deduction is subject to income phase-outs: it reduces once an individual’s Modified Adjusted Gross Income (MAGI) exceeds $150,000 for single filers or $300,000 for married couples filing jointly. Above those thresholds, the deduction is gradually eliminated. The deduction is reduced by $100 for every $1,000 of MAGI above the threshold.

The Role of “Mandatory Service Charges”

A key limitation in the law concerns mandatory service charges, an issue of ongoing confusion in the hospitality sector. Section 224(c)(2)(A) states that “qualified tips” are “such amount[s] paid voluntarily without any consequence in the event of nonpayment, is not the subject of negotiation, and is determined by the payor.” Revenue Ruling 2012-18 outlines four factors distinguishing tips from service charges: freedom from compulsion, unrestricted customer control over amount, absence of employer policy or negotiation, and customer choice of recipient. Mandatory charges, such as automatic gratuities, are service charges, not tips. Proposed regulations reaffirm that only voluntary payments qualify unless customers can disregard or alter added charges without consequence.

In practice, this means that restaurant and hotel employers must take steps to clearly distinguish between voluntary gratuities and automatic service charges in their systems and communications. Menus, receipts, and event contracts should clearly identify any service charges and avoid language implying that they are “tips.” Employers are also encouraged to educate their employees about the distinction to prevent improper reporting on individual tax returns.

The Overtime Pay Deduction

The same legislation also introduced a separate deduction for overtime compensation, up to $12,500 per individual ($25,000 for married filing jointly). Employees who receive overtime pay under the Fair Labor Standards Act (FLSA), or equivalent state laws, may deduct the additional half-time pay from taxable income. Like the tip deduction, this benefit phases out above $150,000 for individuals and $300,000 for joint filers.

For restaurant and hospitality employers, overtime pay is typically easier to track than tip income, since it appears directly in payroll records. Still, employers must maintain accurate timekeeping and classification systems to ensure overtime is correctly reported and eligible for the deduction.

Compliance and Employer Responsibilities

Incorrect reporting or classification may trigger penalties under IRC §§ 6721–6722 for filing or furnishing inaccurate information returns. However, for 2025, employers and other payors will not face penalties for failing to provide a separate accounting of any amounts reasonably designated as cash tips. (IRS Notice 2025-62). To prepare, restaurant operators should review point-of-sale and payroll configurations, confirm that tip and overtime categories are clearly coded, and ensure employees receive accurate year-end wage statements.

Practical Advice

The new deductions for tips and overtime income under H.R. 1 of 2025 represent a significant change in how the federal government treats service-based earnings. While the relief is welcome news for many workers, the burden of compliance largely falls on employers.

Restaurant and hospitality businesses should consult with tax and employment counsel to review their current payroll practices, update tip and service-charge policies, and prepare for IRS rulemaking expected in 2026. As with most tax legislation, preparation and precision are the best safeguards against future disputes.