The Federal Tax Deductions for Tips and Overtime Pay: Opportunities for Restaurants Employers

Transcript

INTRO

The One Big Beautiful Bill Act contains new, temporary laws, including available tax deductions for earnings on tips for tipped employees and overtime wage earnings of all employees.

On this episode of We get work®, we discuss the relevancy of the temporary tax deductions and the big picture practical implications for employers, particularly to restaurants and other businesses that employ tipped workers.

Today’s hosts are Adam Gross, principal in the firm’s New York City office, and Jed Charner, associate in the firm’s Washington, D.C. Region office.  

Adam and Jed, the question on everyone’s mind today is: What are the deductions, what should employers keep in mind, and how will that impact my business?   

CONTENT

Adam Gross
Principal, New York City

Thanks Alitia. Happy to be here today with Jed. We are going to discuss the new One Big Beautiful Bill Act and, specifically, some of the federal tax deductions that apply, with a focus on the restaurant industry in particular. 

As we kick this off, Jed, maybe you can tell everyone what specifically we’re talking about and what the broad strokes of the bill are as they apply to restaurant workers.

Y. Jed Charner 
Associate, Washington, D.C. Region

Sure, thanks, Adam. Great to be here talking about this today with you. We’ll talk about some of the details of the bill and we’ll talk about some broader decisions and ramifications for employers and, specifically, restaurant employers. 

The One Big Beautiful Bill Act, among many other things that it contains, contains new laws that are temporary laws from 2025 through 2028 that have tax deductions available for 

earnings on tips for tipped employees and overtime wage earnings of all employees, not just tipped employees. 

These tax deductions are particularly relevant for restaurant employers and restaurant employees. Restaurants, in particular, have many tipped employees who earn a good portion of their earnings through tips, as well as employees who work more than 40 hours a week and earn earnings through overtime. And therefore, this becomes very relevant to restaurant employers. 

I’ll talk about a couple of details and then kick it back for you to talk about some more of the details of the law. 

But one thing to note: this is a federal income tax deduction. This is not FICA, payroll taxes, Medicare, Medicaid, Social Security. That is not exempt from it. 

And this is also not a state law. This is a federal law passed by U.S. Congress and signed by the president. So this doesn’t exempt or deduct state income taxes. There’s no laws like that on the books right now.

Gross 

I think that’s an important point, Jay, because I’ve seen a lot of confusion on that piece where even from employees as they’ve been communicating with their employer saying, “Do you mean I’m not going to be taxed at all on my tips up to a specific threshold or on my overtime wages?” And that’s actually not the case. We’re really only talking about the specific federal income tax deduction. It’s not applicable to, as you said, state and local taxes.

Charner 

As with every element of this new law, it is incumbent on employers to communicate clearly and directly with their employees who are subject to this, especially tipped employees. In the case of restaurants, about what the bill is and what the bill isn’t because there may be some confusion about it. Number one, it is a tax deduction that an employee, when filing taxes, let’s say for their 2025 income tax return that they’ll file next year in 2026, they can deduct those wages, the overtime wages up to a limitation and the tipped wages up to a limitation we’ll talk about in a moment. It is a deduction when they file their taxes. Therefore, you must file taxes, you must have a social security number and file taxes to get that. The employer still withholds taxes on tipped earnings and on overtime earnings at the time that it is paid. So, employees will not see immediately in 2025 or even as it continues for the next couple of years, employees won’t see an immediate increase in their take-home pay based on this. However, there is IRS guidance about continuing into the future for 2026, about changing withholding levels and such on those earnings. So, it’s really for 2025, because it’s mid-year when this law was passed, there’s not going to be an immediate change in withholdings, but it will be deductible and, to the extent over-withheld, refundable.

Gross 

I think that’s a great point, too. Sure to be another source of confusion with employees questioning their employer and saying, “Why am I being taxed on my overtime from this week or on my tips from this week? Because of the new law, I’m not supposed to be taxed.” At least as Jed just mentioned with respect to 2025, it is not going to be a real time deduction. It’s going to be an end of year deduction where employees will, on their taxes, get the benefit of the deduction. As you said, Jed, moving forward, we might see a change with respect to withholdings into 2026, 2027 and 2028, but we’re waiting for IRS guidance on that piece. 

You mentioned, Jed, thresholds in terms of limitations on these deductions. And I think we can briefly mention that although there is some slight 

additional nuance for the most part. The deductions are limited on the tip side of things to $25,000 per individual, and that could be $50,000 if filing jointly, and $12,500 on the overtime, and $25,000 if filing jointly, with proportional reductions to those maximum deduction amounts for every $1,000 gained beyond the $25,000 in tips or $12,500 in overtime. So, it will ultimately cascade downward. It will also cascade downward for an individual’s income beyond $150,000, or $300,000 in a joint filing situation. There are some limitations on these deductions.

I don’t think that the limitations will apply for many of the workers across the country, but there are certainly some who will be capped. The benefit of these deductions will be capped for those individuals or those households.

Charner 

Definitely, I think it’s a pretty good threshold. I would say for most tipped employees and non-exempt employees who are eligible for and earn overtime, that’s a pretty good threshold of $150,000. Up until which the overtime and tip wages are still deductible. 

Let’s transition a bit and talk about next steps for employers with the passage of this bill, which was actually signed on July 4th, for compliance.

First of all, would you say immediate things for employers to do to ensure continuing compliance?

Gross 

Sure. I’ll take the low hanging fruit since you kicked it to me first. I think that the number one thing, and this is not new, it’s something that hopefully all restaurant employers have already been employing, but it is going to become paramount for now a second reason that employers maintain accurate records of tips earned and tips distributed to employees. If you have a pooled house, obviously it’s important to ensure that you maintain records of tip distribution. That’s true for cash tips and for credit card tips, because, at least with respect to 2025, at the end of the year on the W-2s that the employers are now providing their employees, they are going to have to explicitly specify the number of tips received and the overtime earnings received forindividual employees so that those employees can apply for the deductions that they’re entitled to under the bill.

Charner 

Next step after that, I would say, is communications with employees. We talked about some potential misnomers from hearing about the bill, reading quickly about the bill, seeing an X post about the bill, et cetera. There could be misnomers such as that there’s no state income tax, such as there’s no FICA taxing, such as the fact that we talked about previously 

that why is even federal income tax still being withheld in 2025. To avoid issues, it is incumbent upon restaurant management, HR, whoever it is that has those communications with employees to have clear communications to employees about what the bill is, what the bill isn’t, what it looks like now, the fact that things may be changing with IRS guidance for 2026 and the future, such as what you just said.

Instructing employees that all tips, whether cash or credit card tips, must be reported because they need to be accounted for in order to understand what can be deducted from federal income tax obligations. We have, actually, if anyone wants to reach out to us, FAQs that employers, restaurants can disseminate to employees. But having clear communications at the front end can avoid a lot of questions, a lot of confusion, a lot of complaints.

Gross 

I think that’s an important point. And I’ll just add that that communication is not just to the tip and overtime eligible employees, because who are the individuals who are going to be fielding a lot of these questions is likely to be management at the restaurant or HR, depending upon the operation. It’s important to ensure that those individuals are informed about the law, that they understand 

the implications of the law, that they’re able to either answer the employees’ questions or direct them to resources or to individuals within the organization who can. I think it’s a two-fold communication process. You have to ensure that our managers are fully aware of the implications of the law and how to field employee questions, which I am sure, and I assume you agree, Jed, are going to come 

if not now, certainly when we get into the end of the year and to tax season at the beginning of next year. I think that those questions are going to be common from employees and they’re likely going to broach them with their managers in the first instance.

Charner 

Absolutely, anytime there’s a change in the law or anytime there’s generally an issue coming up, either ensure that all managers are aware of the issue and aware of responses or appoint a point person to be the person to answer those questions and ensure that all managers are aware of who the point person is so that they can direct inquiries to the right person who can give the correct answers to employees to avoid confusion and complaints.

Maybe let’s veer toward bigger picture sort of business planning strategies stemming from this new law. I’ll kick it off with one thing that I’ll mention for your comment and then you can add in other thoughts you have about future planning. One important feature 

or limitation of this law is the deduction for tipped wages is specifically for tipped wages. The definition of tips are voluntary tips that customers pay for the service they receive. At a restaurant, it could be a bartender, could be a server, could be other people that serve the customer. That’s a voluntary tip. 

There is something else called a service charge that you see in many restaurant contexts and that is a mandatory service charge. You get your bill and there’s an automatic 20% service charge. Some places, it may be for a party, a large party or a planned event and at some restaurants that is just standard. That every time you get your bill you have that.

The exemption or the deduction that is available is only for tips, voluntary tips, not for service charges. This is a business decision issue and this is also a tax issue now: do you charge mandatory service charges? Typically, when there are mandatory service charges, there are less voluntary tips from customers. There’s already that service charge added to bills 

that is not exempt from the federal income tax. The employer will have to pay the service charge that is then distributed to the servers, to the bartenders or whoever, that is fully taxed, all federal income tax, and of course all other taxes. In order for a restaurant to enable its tipped employees, or any employees, to take advantage of that, it has to be voluntary tips. Therefore, there’s a business decision of do you want to enable your employees to take advantage of that? And, instead of charging mandatory service charges, if you already do that, change the tips, or do you want to keep the structure and then your employees can’t take advantage of it?

Gross 

I think that’s a great point. And it’s certainly something that the service charge model or the mandatory gratuity model has gained popularity significantly over the years. And it’s something that, previously, employees often were on board with because it eliminates the risk of someone not leaving a tip at all or leaving a tip below accepted norms. Now, there’s obviously a vested interest in employees, in money left by customers being classified as a tip for employees to benefit from the tax deduction. That issue is certainly going to be on employees’ minds. And I imagine it will be the source of discussions between employees and their employers in terms of how these gratuities are structured and whether they are going to be structured in a way that enables them to benefit from the tax deduction. 

I’d also note that because previously it probably did not register on employees minds to the same degree that it now will moving forward, whether something was technically a tip or not, if the amount that the employer is receiving was unchanged. Now, if it’s not considered a tip and could give rise to frustration on employees’ side, I think it could raise awareness of the issue as to whether 

that service charge or mandatory gratuity is factoring into the overtime rate of pay in the event that someone is working more than 40 hours in a week. One of the issues that can come up is that if you have a mandatory gratuity or a service charge, by law, that’s not a discretionary tip. A tip must be discretionary. So, while tips don’t impact overtime rates of pay, obviously, service charges and involuntary gratuities do. 

And if there is more awareness of the difference between the two as a result of this new legislation and the tax deduction available, I think it’s something that employers should certainly be focused on to ensure that they are cognizant of their responsibilities under the overtime provisions of the FSA and applicable state law as well.

Charner 

Definitely, and I guess this is an issue that falls into the category of something we talked about three minutes ago, and that is, again, communications with employees. To the extent that a restaurant was imposing mandatory gratuities, which in the law is called a service charge, and there is no tax deduction available for service charges distributed to employees, and if a restaurant is considering changing that, the restaurant doesn’t need to 

ask employees what they think, but they may want to, like you said. A server may be thinking about, well, the mandatory service charge is good, especially if it’s 100% distributed to employees, because it has a mandatory amount and it’s not subject to low tippers customers. But they may want to think about, well, do I, would I benefit more from paying no income tax, whatever my income tax rate is, or would I benefit more from having sort of a mandatory 18% or 20% or whatever it is that some of those restaurants tend to charge now.

Gross 

I think that’s absolutely true. And I say all the time, and I imagine, Jed, you do, too, to the clients that you are advising in any industry, but I think with a special importance in the restaurant industry where a lot of the tip formulas and tip pooling documents are complicated and involve spreadsheets, transparency with employees so that they understand what they’re being paid, how it’s being calculated 

what the decision points are, that transparency is a tremendous tool in terms of risk mitigation. Because when employees don’t understand what is happening or how their compensation is being calculated, they’re more likely to be suspicious about their pay or how it is being calculated. I think that that transparency with employees, that communication, is paramount. 

In just the few minutes that we have left, Jed, I know you and I both wanted to talk about just some other big picture practical implications of this law. I’ll add one and then, Jed, maybe you can tack on. 

It has already been a struggle for all of you restaurant owners out there, you are all fully aware of the struggle it is sometimes to hire suitable managers for your restaurants. That’s because managers can’t participate in the tip pool and it is already difficult as a restaurant to afford for it to be feasible economically to pay a manager a sufficient wage to create a sufficient incentive for that manager to be willing to come out of the tip pool as a server, as a bartender or as a tipped employee and be willing to accept the manager role. 

That difficulty is likely to be exacerbated as a result of this new law. Because, now, on top of the fact that the individual who’s being promoted or being hired as a manager can no longer receive tips, they’re also not getting the benefit of the deduction on their tips. There’s an even stronger financial incentive for the individual to remain in a tipped position, which we expect is going to make it even more challenging for restaurants to find 

managers, individuals who are willing to come out of the tip pool and assume a managerial role because they are going to then be forgoing, at the very least, the deduction for tips and, depending upon whether they are a salaried and exempt manager versus an hourly one, they may also be forgoing any potential deduction for overtime hours. So, this is absolutely a trend that’s already been in place, but I think that this law is only going to make that challenge more steep for employers navigating the impact of the new law.

Charner

I agreed 100%. I think that restaurants need to be prepared and understand the considerations for when managers. Supervisors do come forward and say, “I don’t want to be considered exempt anymore from overtime wages” and “I want to participate in the tip pool” if they currently are not. If they’re indeed real managers, then they are not allowed to be participate in the tip pool.

There’s actually a little bit of a hidden trap there for employers that they need to know of this to avoid an issue of compliance with tip pooling and tip credit. And the issue is as follows: if you indeed have a manager who is exempt and for a manager to be exempt, they need to be paid. 

I’ll talk about FLSA, the federal level. There are some state nuances and city nuances in certain cities. Let’s talk about a federal FLSA level. In order for a manager to be exempt, they need to be paid on a salary basis, guaranteed salary of $684 a week. That’s the salary basis test. And then they also need to satisfy the duties test of the managerial exemption. That is that they have authority to hire and fire employees or at least make recommendations that are generally followed. They manage consistently two or more employees and their primary duty is managing employees. If there’s nothing wrong with paying, changing the status of a manager and saying, “I will make you be non-exempt by no longer paying you on a salary basis. I will pay you on an hourly basis. And that is based on hours you work, you clock in, you clock out. Pay you an hourly amount.” And then they lose the exemption and then they are entitled to overtime wages. So, there is an opportunity to take a manager and make them no longer exempt from overtime wages and by paying them on an hourly basis, they don’t satisfy the salary basis test of a guaranteed salary of $684 per week. In that case, they will be entitled to overtime wages and there is an opportunity to make calculations and say, well, if I try to get it exactly right, 

and I think I know how many hours they’re working generally a week, they can earn the same amount of gross money, but their take home after the tax deductions on the overtime will be more because the overtime is not taxed. The hidden trap is that managers are prohibited from participating in a tip pool. So, if the idea is then they can also serve some customers, do some bartending, those kinds of things, and then also participate in that tip pool. The test for whether a manager can participate in a tip pool is solely based on the duties test, the managerial duties test. They do not need to satisfy the salary basis test in order to be prohibited from participating in a tip pool. That means that if you change the compensation method for a manager, say I’ll pay you hourly. You are then required to pay them overtime and then they can take advantage of the overtime wages deduction. But they still cannot participate in the tip pool if they still basically are doing primary duties of a manager, if they still have authority to hire and fire, if they satisfy everything and are doing the same things that they did previously when you were paying them a salary and they were working 50 hours a week with no overtime.

And so that is a trap. You can come to an issue where you have a manager impermissibly participating in a tip pool, you invalidate your tip pool, and you invalidate your tip credit. You will then be required to pay full minimum wage, not the lower tip credit minimum wage, to your tip employees. And employees can bring claims for improper participation in a tip pool by a manager. And they can bring claims for the tips that they lost from the tip pooling, they being owed those tips that went to the manager. That gets into a world of math problems that you don’t want to get into. So, if you restructure a manager’s duties to no longer have primary duties of being a manager, or if they don’t make hiring and firing decisions at all, then they can participate in a tip pool. 

But if they’re doing the same things that yesterday you were treating them as exempt for properly because of their duties, changing the way they’re paid doesn’t solve the tip pool, tip credit issues that arise.

Gross 

I think that’s a great point, Jed. And I think we can perhaps end on this, which is the logical extension of that: restaurants are already dealing with the difficulty in hiring managers. Now you’re going to have managers with even more incentive to want to be classified as non-exempt or the opportunity to earn overtime and participate in the tip pool. You’re struggling as a restaurant because you don’t have sufficient managerial coverage. That is going to lead to a situation where you say, 

“Well, John can be a manager on Monday and Wednesday and Friday, but on Tuesdays and Thursdays, he’ll just be a regular bartender.” So, now John’s managing part-time, he’s bartending part-time, and he’s receiving tips during the times that he’s bartending, not on the shifts where he’s managing. In theory, there’s nothing per se unlawful about that arrangement. The problem is that you’re starting to blur lines. The question is not always whether is it a defensible practice. It’s whether it’s likely to create an issue amongst the employees who are sharing the tips with John, in my example, on Tuesdays and Thursdays, when they see that he’s their manager on Mondays, Wednesdays, and Fridays. It’s very difficult sometimes for an individual to wear a manager’s hat half the time, a non-managers had the other half of the time without generating complaints from the other participants in the tip pool. I think that that sort of scenario already exists and it’s just going to become more prevalent in the aftermath of this new legislation. Certainly, something that I am sure you and I, Jed, amongst the rest of our restaurant industry experts here at Jackson Lewis will be tracking and dealing with moving forward in the aftermath of this new legislation.

Charner 

Definitely. This last topic that we’ve been talking about is, essentially, the OBBBA created some really good benefits for tipped employees, for overtime eligible employees. But it created sort of a disincentive in some ways for some managers, depending on what level of pay they are being paid, disincentive to be a manager who’s exempt and ineligible to participate in a tip pool and create some potential compliance issues where a restaurant is really solely trying to help a manager, to incentivize being a manager because they want happy managers and they need managers. Some traps there and some potential conundrums for people who could be managers or who are managers that are sort of hidden or become exacerbated to some degree by the OBBBA. So, hopefully, we provided some good tips on tips.

Gross

Thanks very much, Jed. This was a lot of fun. And as always, everyone, you can reach out to your local Jackson Lewis lawyers with any questions on this topic or anything else involving your workplace. Thank you, everyone.

Charner 

Thank you.

OUTRO

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