No Tax on Tips & Overtime in 2025: What Hawaii Employers Must Know

Hawaii's hospitality, food service, and tourism industries employ tens of thousands of tipped workers. Our hotel and restaurant staffs routinely earn meaningful portions of their income from gratuities, and many of our hourly workers regularly clock overtime during peak seasons. The OBBBA is a significant change for these workers — and it puts new reporting responsibilities on their employers.

Here's what you need to understand, what you need to do, and how the compliance requirements ramp up going into 2026.

1. What Changed: The OBBBA in Plain English

The One Big Beautiful Bill Act, signed into law in 2025, introduced a package of tax changes affecting both individuals and businesses. Two provisions are directly relevant to Hawaii employers right now.

Both provisions work as above-the-line deductions — meaning employees can claim them whether or not they itemize. Employees claim these deductions on their personal Form 1040 when they file their 2025 tax return. You don't change withholding. You don't adjust tax tables. But you do need to track these amounts and report them — because your employees can only claim a deduction on income they can document.

Employees claim both deductions on Schedule 1-A of their Form 1040 (see the IRS overtime FAQ, FS-2026-01, January 2026).

2. No Tax on Tips — What Qualifies

The OBBBA allows employees to deduct up to $25,000 of qualified tip income per year from their federal taxable income. This deduction is available for tax years 2025 through 2028.

What Counts as a "Qualified Tip"

Not every tip qualifies. The IRS defines a qualified tip as a voluntary payment where the customer controls whether to tip and how much — standard tips in cash or on a card, including amounts received through tip pools or tip sharing. The occupation must customarily and regularly receive tips (predating December 31, 2024), and the tips must be reported on a W-2, 1099-NEC, 1099-MISC, 1099-K, or Form 4137.

What Does NOT Qualify as a Tip

Mandatory service charges don't qualify — those auto-gratuities on large-party checks that customers can't change are wages, not tips, regardless of the label. Tips earned in a Specified Service Trade or Business (such as financial services or consulting) are excluded, though under IRS Notice 2025-69 an employee in a listed tipped occupation is treated as outside a specified service business until final regulations take effect. Married filing separately: not eligible.

Annual Limits and Phase-Outs

Phase-out reduces the deduction by $100 for every $1,000 over the threshold. For self-employed workers, the deduction also cannot exceed net income from the business in which the tips were earned.

3. No Tax on Overtime — What Qualifies

The overtime deduction covers only the premium portion of FLSA-required overtime — the "half" in "time-and-a-half." If an employee earns $20/hr and works 10 hours of overtime, they're paid $300 for those hours (10 × $30). The $200 straight-time portion is regular wages. The $100 premium is what qualifies for the deduction.

The "Half" Rule — How It Works

Who Can Claim It

FLSA non-exempt employees only — people for whom overtime is legally required under the Fair Labor Standards Act. Salaried exempt employees (executive, administrative, professional, outside sales, highly compensated) don't qualify, even if their employer voluntarily pays them overtime. Covers federal and private-sector workers. Available whether the employee itemizes or not.

Annual Limits and Phase-Outs

The deduction applies to tax years 2025–2028.

4. W-2 Reporting: What's Required Now vs. Starting 2026

This is where it gets practical for employers. The IRS acknowledges that payroll systems weren't designed to separately track and report these amounts yet — and they've given employers a one-year runway to get ready.

2025: Transition Year (Penalty Relief in Effect)

Under IRS Notice 2025-62, employers will not face penalties for failing to separately report qualified tip income or overtime premium pay on 2025 W-2 forms — as long as aggregate wages are correctly reported. The IRS also confirmed that Forms W-2 and 1099 for 2025 will not be updated with dedicated boxes for these amounts.

However, employers are strongly encouraged to voluntarily provide employees with the information they need to claim their deductions. The IRS recommends:

The IRS recommends using Box 14 of Form W-2 with a label like "Qualified OT" or "FLSA OT Premium." For tipped employees, a written statement listing their occupation and annual cash tip total is the cleanest documentation. Deliver it through your payroll portal or include it with year-end materials.

2026 Forward: Mandatory Separate Reporting

Starting with tax year 2026 W-2 filings, separate reporting of qualified overtime and tip income will be mandatory. The IRS draft 2026 Form W-2 adds Box 12 code TP (cash tips reported to the employer), code TT (qualified overtime), and a new Box 14b for the tipped occupation code. Employers who don't comply will face information reporting penalties starting at $60 per form.

5. Hawaii-Specific Tip Considerations

Hawaii's economy runs on tips. Hotels, restaurants, luaus, activity companies, transportation, spas — in our biggest employment sectors, gratuities are a real and meaningful part of take-home pay, not a rounding error. Several Hawaii-specific rules interact with the OBBBA that employers here need to understand.

FICA Tip Credit (Section 45B)

This existed before the OBBBA. For tax years beginning after 2024, the OBBBA extended it to beauty service businesses (barbering and hair care, nail care, esthetics, body and spa treatments). Food and beverage employers can claim a federal income tax credit equal to their share of FICA taxes paid on tips above $5.15/hour. It's an employer credit, not an employee deduction — a different benefit entirely — but it requires the same clean tip-tracking records that the new W-2 reporting demands. If you're not already claiming Section 45B, talk to your accountant.

The 8% Tip Reporting Rule

If you run a large food or beverage establishment (tipping is customary and you normally had more than 10 employees on a typical business day in the prior year), the IRS requires that tips reported to you total at least 8% of gross receipts. If employees report less, you as the employer may have to allocate the difference on W-2s (Box 8). Clean, accurate daily tip reporting is how you stay out of trouble here.

Tip Pooling in Hawaii

Hawaii follows federal law on tip pools. Under the FLSA as currently interpreted, tip pools may include back-of-house employees (cooks, dishwashers) as long as the employer does not take a tip credit. The OBBBA deduction applies to amounts received through legitimate tip pool distributions, not just direct tips. Your payroll records need to reflect the distribution, not just the collection.

Hawaii State Income Tax on Tips

Starting with tax year 2026, Act 35 (2026) conforms Hawaii income tax law to the federal deduction for qualified tips (IRC section 224, up to $25,000). Hawaii does not conform to the federal deduction for qualified overtime compensation (IRC section 225), so overtime pay stays fully taxable at Hawaii's income tax rates (1.4%—11%). Tips remain subject to Hawaii withholding; employees claim the deduction when they file. Employees need to understand the difference. Set expectations clearly during onboarding.

6. Common Mistakes That Will Cost Your Employees

Most of these aren't intentional. They're the result of payroll systems that weren't built with the OBBBA in mind, or front-of-house managers who haven't been briefed on the difference between tips and service charges. But the employee who loses their deduction because of an avoidable recordkeeping gap doesn't care about intent.

Mistake 1: Treating Service Charges as Tips

A mandatory 18% automatic gratuity added to large parties is a service charge, not a tip. When you distribute service charge revenue to employees, it's wages — subject to payroll taxes, but not qualifying for the tip deduction. Many Hawaii restaurants run both. Keep them separate in your payroll records.

Mistake 2: Not Tracking the OT Premium Separately

Most payroll software stores total overtime pay — the $30/hr total — not the $10/hr premium. Employees need the premium amount to calculate their deduction. If your software doesn't isolate the half-time premium, your employees will either miss the deduction or have to reconstruct it manually from every paystub.

Mistake 3: Assuming Exempt Employees Qualify

Your salaried manager who you voluntarily pay overtime during a big event does not qualify. Your FLSA-exempt employees — and Hawaii has many in hotel management, accounting, and administration — cannot claim this deduction regardless of how much overtime they work.

Mistake 4: Not Providing Box 14 Reporting in 2025

The penalty relief is real for 2025, but remember: your employee is still trying to file their 2025 taxes in early 2026. If they can't find their OT premium amount because your W-2 doesn't include it, they call you. They file late. They miss the deduction. Do your workforce a favor and configure Box 14 now.

Mistake 5: Ignoring State Tax

Employees who hear "no tax on tips" may assume all of their Hawaii state tax on tips and overtime is waived. It isn't: Hawaii's conformity starting in 2026 covers the qualified tips deduction only, not the overtime deduction. Under-withholding for state purposes creates a balance due at filing time. Clear communication to employees prevents surprises.

7. How PDS Tracks Tips, OT & Keeps Your W-2s Compliant

Hawaii payroll services from Pacific Data Services have covered local businesses since 1969. When the IRS issues new guidance, we move quickly — because your employees' ability to claim a tax deduction depends on how accurately their W-2 is prepared.

8. Frequently Asked Questions