Payroll compliance for tips and overtime is not a task to revisit only when W-2s are prepared. The One Big Beautiful Bill Act created two new federal income tax deductions, the qualified tips deduction under Internal Revenue Code Section 224 and the qualified overtime compensation deduction under Section 225, and for tax year 2026 an employee’s ability to claim either deduction depends on how accurately a business tracks and reports those amounts throughout the year, not on what gets reconciled in January. The transition relief that lets employers estimate these figures for 2025 under IRS Notice 2025-62 does not carry into 2026. A business that waits until year end to address this is working from twelve months of payroll data that may already contain errors that are far harder to correct after each pay period has closed than while it is still open. Tax problems are easier to manage before the IRS process controls the timeline. If a practical review of exposure, planning options, or IRS correspondence would help, speak with Steve Perry, EA. Call 678-717-9818, email steve@bookstaxesatl.com, or connect on LinkedIn at www.linkedin.com/in/steveperrybtm.
Why the deduction now depends on the W-2
For 2025, the IRS confirmed that Forms W-2 and 1099 would not be updated to separately report qualified tips or qualified overtime, so employers were permitted to approximate these amounts using any reasonable method, and Notice 2025-62 waived penalties under Internal Revenue Code Sections 6721 and 6722 for that year alone. That relief was explicitly a one-year transition, not a permanent accommodation.
Beginning with tax year 2026, the finalized General Instructions for Forms W-2 and W-3 require separate reporting through two new box 12 codes: TP for the total amount of cash tips reported to the employer, and TT for the total amount of qualified overtime compensation. Employers reporting tips under code TP must also enter the employee’s Treasury Tipped Occupation Code in the new box 14b. Non-employee payors face parallel requirements on Form 1099-NEC and Form 1099-MISC. The IRS has stated that employees generally may claim the qualified overtime deduction only for amounts reported through these designated codes starting in 2026, which means a payroll system that has not been configured to capture this information correctly does not just create a reporting gap. It can prevent an otherwise eligible employee from claiming a deduction Congress specifically created.
What qualifies, and what does not
Both deductions are narrower than the phrase “no tax on tips and overtime” suggests, and the distinctions matter for how payroll should be coded.
Under Section 225, only the portion of overtime pay required by the Fair Labor Standards Act qualifies, generally the additional half in a time-and-a-half calculation, not the full overtime wage. The 2026 W-2 instructions and Publication 15-T make clear that box 12 code TT should reflect only that premium portion. Overtime paid under a state law, a collective bargaining agreement, or a policy that exceeds the FLSA requirement is not qualified overtime compensation for this purpose, even though it appears on the same paycheck.
Under Section 224, a qualified tip must be a voluntary cash or cash equivalent payment received by a worker in an occupation on the IRS list of occupations that customarily and regularly receive tips. Mandatory service charges generally do not qualify unless the customer retains the option to reduce or eliminate the charge. Before assuming a tax position is settled for the year, consider having Steve Perry, EA evaluate the underlying records, IRS risk, and planning opportunities. Call 678-717-9818, email steve@bookstaxesatl.com, or connect on LinkedIn at www.linkedin.com/in/steveperrybtm.
Where payroll errors turn into IRS exposure
Once the 2025 transition relief expires, ordinary information return penalties apply to incorrect or missing box 12 and box 14b entries on 2026 Forms W-2. Under the 2026 General Instructions for Forms W-2 and W-3, the penalty structure for filings due after December 31, 2026, runs from $60 per form for corrections made within 30 days, up to $340 per form for forms that are not corrected at all, with higher annual maximums for larger employers. These are civil penalties under Internal Revenue Code Sections 6721 and 6722, assessed per form, which means the exposure scales directly with headcount and with how long an error goes uncorrected.
A payroll system that has not been updated before the first 2026 pay period creates a full year of records that will eventually need to be reviewed, and any correction after the fact generally requires a Form W-2c for each affected employee. The following items are worth confirming during 2026 rather than after it closes, and there may be other verification steps depending on a business’s specific payroll structure and facts and circumstances.
- Confirm each tipped employee’s occupation appears on the IRS list of occupations that customarily and regularly receive tips, and assign the correct Treasury Tipped Occupation Code for box 14b.
- Update payroll software to code cash tips under box 12 code TP separately from regular wages, distinct from any mandatory service charges.
- Configure overtime calculations to isolate only the FLSA premium portion under box 12 code TT, rather than total overtime pay.
- Reconcile running totals for codes TP and TT against box 1 wages, box 7 Social Security tips, and internal timekeeping records on a quarterly basis rather than at year end.
- Confirm that any non-employee payments subject to these rules are being tracked correctly for Form 1099-NEC or Form 1099-MISC reporting.
Payroll compliance for the tips and overtime deductions is not a form that gets filled out correctly in January because the surrounding processes were right all year. It is a running total that reflects hundreds of individual coding decisions made pay period by pay period, and the IRS’s shift from optional approximation in 2025 to mandatory, penalty backed reporting in 2026 raises the cost of getting those decisions wrong. Good tax outcomes come from managing the year before the IRS forces the issue. For help reviewing next steps, speak with Steve Perry, EA. Call 678-717-9818, email steve@bookstaxesatl.com, or connect on LinkedIn at www.linkedin.com/in/steveperrybtm.
Does the 2025 penalty relief for tip and overtime reporting carry over to 2026?
No. Notice 2025-62 waived penalties under Sections 6721 and 6722 only for taxable year 2025. Beginning with 2026 forms, the standard information return penalty structure applies.
Does all overtime pay qualify for the Section 225 deduction?
No. Only the FLSA required premium portion, generally the additional half in time-and-a-half pay, is qualified overtime compensation. Overtime required by state law or a union contract in excess of the FLSA rate does not qualify.
Do mandatory service charges count as qualified tips?
Generally, no. A mandatory service charge is not a qualified tip unless the customer retains the option to reduce or eliminate the charge, since the payment must be voluntary.
What happens if a 2026 Form W-2 is filed without the new box 12 codes?
The employer may be subject to information return penalties under Sections 6721 and 6722, and the affected employee may be unable to substantiate the deduction without a corrected Form W-2c.
How often should payroll totals for tips and overtime be reviewed during 2026?
Reviewing totals quarterly, rather than waiting until year end, allows coding errors to be corrected while the underlying pay period records are still current and easy to verify.
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