15 July 2025 Several changes to compensation and benefits provisions included in final budget reconciliation legislation for FY 2025
Final budget reconciliation legislation (H.R. 1), signed into law on July 4, 2025 (the Law), contains several provisions affecting compensation and benefits, including individual deductions for tips and overtime, and the tax treatment of various employee benefits. The Law creates individual deductions for tips and overtime, which are premised on new employer reporting, and makes changes to existing provisions, including the following:
The Law does not include a prior proposal to increase unrelated business income tax of certain tax-exempt entities for commuting-related benefits provided to employees. See Tax Alert 2025-1120 for a discussion of those provisions. Tips are generally includible in gross income and may also be subject to federal income tax withholding, Social Security/Medicare (FICA) and federal unemployment insurance (FUTA) taxes. Tips are defined differently depending on the context and may include cash tips received directly from customers, electronically paid tips from credit and debit card charge customers and tips received under a tip-splitting or tip-pooling arrangement. Employees generally must report their tips to their employers. Employers must keep the employee tip reports, pay FUTA and the employer's share of FICA taxes, and withhold federal income tax and the employee's share of FICA taxes on tips paid to employees. State and local taxes may also apply to tips. IRC Section 45B allows certain food and beverage establishments to elect to claim a business tax credit equal to the employer's share of FICA taxes paid on tips that exceed those treated as wages for purposes of meeting the federal minimum wage requirements as in effect on January 1, 2007. The Law creates a new IRC Section 224, which allows a federal income tax deduction for qualified tips of up to $25,000 for both employees and independent contractors for tax years 2025 through 2028. The deduction is available to itemizers and non-itemizers and begins to phase out for adjusted gross income (AGI) over $150,000 ($300,000 joint). Married taxpayers must file jointly and all taxpayers must include their Social Security Numbers (SSNs) to claim the deduction. Qualified tips are defined as any cash tip received by an individual in an occupation that customarily and regularly received tips on or before December 31, 2024, as provided by Treasury. Within 90 days of enactment, Treasury is directed to publish a list of occupations that customarily and regularly received tips prior to 2025. The definition of qualified tips includes tips paid in cash or charged, as well as pooled tips. Qualified tips do not include any amounts received by an individual unless the amount is paid voluntarily, is not subject to negotiation, and the amount is determined by the payor. The Law imposes a new statutory requirement to report cash tips and the individual's occupation on certain Forms 1099 and on the Form W-2. This reporting will apply beginning with Forms W-2 due on February 2, 2026, for calendar year 2025. The Law provides a transition rule for reporting with respect to years beginning before 2026, allowing certain taxpayers to "approximate a separate accounting of amounts designated as cash tips by any reasonable method specified by the Secretary." The transition rule does not apply to Form W-2 reporting by employers. The Law also expands the availability of the IRC Section 45B tip credit to tips received by employees for barbering, hair care, nail care, esthetics, and body and spa treatments. This provision applies to tax years beginning after December 31, 2024. No deduction is allowed for tax years beginning after December 31, 2028. This provision applies only to "cash tips," the definition of which includes charged tips and pooled tips. Because the tip deduction is claimed on an individual's income tax return, the change to employer reporting requirements for tips will be minimal. Tips subject to Social Security taxes are currently reported in Box 7 of the Form W-2. The Law codifies a requirement that the Form W-2 include the total cash tips the employee reports to the employer, as well as the employee's occupation. Thus, employers will separately report all tips, including tips over the Social Security wage base. Tips will still be included in Box 1 income, but Treasury is directed to modify the withholding procedures to take the new deduction into account. The retroactivity of this provision may present practical challenges for employers. While certain of the new reporting requirements are eligible for transition relief, tip reporting by employers is not eligible for this relief. The new reporting requirement applies to Forms W-2 for 2025, which are to be filed and furnished by February 2, 2026. Overtime is generally includible in gross income and subject to federal income and employment taxes. Employers must keep certain records for employees eligible for overtime. Employers must report overtime on Form W-2 along with other wages, but there is no requirement to separately account for overtime compensation on the form. The Law creates new IRC Section 225, which allows a federal income tax deduction for qualified overtime compensation of up to $12,500 ($25,000 in joint) that is reported on Form W-2 for tax years 2025 through 2028. The deduction is available to itemizers and non-itemizers and begins to phase out for AGI over $150,000 ($300,000 joint). Married taxpayers must file jointly, and all taxpayers must include their SSNs to claim the deduction. Qualified overtime compensation is defined as overtime required by Section 7 of the Fair Labor Standards Act of 1938 or FLSA (that is, federal overtime) that is in excess of the regular rate (as defined in the FLSA) at which the individual is compensated. The Law includes a transition rule for reporting with respect to tax years beginning before 2026, allowing certain taxpayers, including employers, to "approximate a separate accounting of amounts designated as qualified overtime compensation by any reasonable method specified by the Secretary." This provision is effective for tax years beginning after December 31, 2024. No deduction is allowed for tax years beginning after December 31, 2028. As with tips, overtime payments are still to be included in Form W-2, Box 1 income, and Treasury will modify the withholding procedures to take the new deduction into account. The Law also adds a requirement, as with tips, that the Form W-2 separately report overtime. Unlike tips, there is currently no requirement to separately report overtime on the Form W-2. Although employers must already comply with federal overtime requirements, some employers are also subject to other pay differential rules for overtime (e.g., under state law or collective bargaining agreements) and could face practical challenges distinguishing the portion of the pay differential that is attributable to federal overtime in the manner needed to comply with this new reporting requirement. The retroactivity of this provision may present additional practical challenges for employers. The Law adds transition relief for employers, allowing approximation of the overtime amount for Forms W-2 due on February 2, 2026, but only as specified by Treasury. Under IRC Section 162(m), an employer cannot deduct compensation in excess of $1 million paid to covered employees of a publicly held corporation. Covered employees include (1) anyone serving as CEO or CFO during the year, (2) the next three highest compensated officers, and (3) any individual who was a covered employee in any previous tax year beginning after December 31, 2016. For tax years beginning on or after January 1, 2027, covered employees also include the five highest compensated employees — not limited to officers — who are not already treated as covered employees under (1) or (2) (although these may include individuals included in (3)). Although no statutory aggregation rule has existed, since 1995, the IRC Section 162(m) regulations have relied on IRC Section 1504 to aggregate certain corporate entities with the publicly held corporation. The Law introduces a statutory aggregation rule to IRC Section 162(m). When a specified covered employee is paid by different members of a controlled group, the amounts will be combined for purposes of the $1 million limit based on rules under IRC Section 414. The allowable deduction will be divided among the members based on their pro-rata share of the total compensation paid to the covered employee. This provision may have only modest effects for most groups that include publicly held corporations. Although IRC Section 414 applies to all types of entities and IRC Section 1504 only applies to corporations, regulations with respect to the prior law already applied IRC Section 162(m) to a publicly held corporation's distributive share of a partnership's compensation deduction. Thus, IRC Section 162(m) already applies to some extent in corporate structures commonly referred to as "Up-Cs" and "Up-REITs." This provision will have the greatest impact on entities that are not currently aggregated with a publicly held corporation under IRC Section 1504 but will be aggregated under IRC Section 414. A prototypical example is a taxable REIT subsidiary (commonly known as a TRS) owned by a partnership (commonly known as an operating partnership or OP). Modification of excise tax on excess compensation for tax-exempt organizations and related taxpayers IRC Section 4960 imposes an excise tax of 21% on compensation paid to a covered employee of a tax-exempt organization that exceeds $1 million, and on any excess parachute payment made to a covered employee. Covered employee is defined as one of the five highest compensated current or former employees for the applicable tax year. Once an employee becomes a covered employee, the employee retains that status indefinitely. The Law amends IRC Section 4960(c)(2) by modifying the definition of covered employee to include any current or former employee who was employed by a tax-exempt organization or any predecessor entity in a tax year beginning after December 31, 2016. The provision removes the five-employee limit on the number of new employees that are added to the list of covered employees each year. For tax-exempt entities with more than five employees with compensation over $1 million, this expands the number of covered employees whose compensation is subject to the excise tax. For organizations whose five highest compensated employees in a given year have compensation under $1 million, it eliminates the need to track their covered employee status. Under current law, a tax-exempt organization with all of its employees in a single legal entity may have fewer covered employees than it would if its employees were employed by separate legal entities, a disparity that is eliminated by this provision. IRC Section 274(o), added by the TCJA and effective for amounts paid or incurred after December 31, 2025, disallows deductions for all food, beverage and operational expenses associated with an employer-operated eating facility, and any expense for meals provided to employees on the business premises for the convenience of the employer. The Law adds an exception to this disallowance by cross-reference to IRC Section 274(e)(8), which excepts expenses for goods or services sold by the taxpayer in a bona fide transaction for adequate and full consideration. The Law adds a further exception for the expense of food or beverages provided on certain fishing vessels, fish processing facilities, and oil rigs. The addition of the IRC Section 274(e)(8) exception will help taxpayers, such as restaurants, that are both in the business of selling food to customers and providing that food to employees. The exception has previously been interpreted by the Joint Committee on Taxation (JCT) to include food prepared for customers that is also provided to on-shift employees. This interpretation was adopted into Treasury regulations applying IRC Section 274(e)(8) to IRC Section 274(n), the 50% deduction disallowance for food and beverage expenses. A prior JCT explanation and Treasury preamble have observed that employers selling food to employees for full fair market value may also rely on the IRC Section 274(e)(8) exception, but it is not clear that the exception is available in the case of an employer that sells food to employees at a discount. Employer-provided childcare credit: The Law amends IRC Section 45F(a) by increasing the employer-provided childcare credit from 25% to 40% of qualified childcare expenditures (and from 25% to 50% for eligible small businesses). The total credit limit increases from $150,000 to $500,000 ($600,000 for small businesses) per tax year. This is effective for amounts paid or incurred after December 31, 2025. Paid family and medical leave credit: The Law permanently extends, with some modifications, the paid family and medical leave credit, which is a general business credit under IRC Section 45S equal to 12.5% of eligible wages paid to qualifying employees during any period they are on family and medical leave. The credit currently disqualifies employers that do not meet the required base of offered leave after subtracting out the base required under state or local law. The credit was set to sunset at the end of 2025. The Law will allow employers that were previously disqualified by the statute's disregard of leave required by state or local law to qualify by counting the required leave for eligibility purposes. As before, the Law continues to disregard such required leave for calculation of the credit, thus permitting the credit only on amounts not required by state or local law. The Law further allows eligible employers to elect to claim the credit for a percentage of premiums paid for insurance policies that cover paid family and medical leave for qualifying employees. Employers may choose to claim the credit based on either wages or premiums, but not both. Finally, the Law now allows employers to limit the paid leave benefit to employees working at least 20 hours per week. This applies to tax years beginning after December 31, 2025. Permanent extension of exclusion for certain employer payments of student loans under educational assistance programs: Under IRC Section 127, an employee may exclude from gross income up to $5,250 annually of educational assistance provided by the employer to the employee, as long as certain requirements are met. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) added payments on student loans as a permitted category of educational assistance, subject to a December 31, 2020, sunset, which was later extended to December 31, 2025, by the Consolidated Appropriations Act of 2021. The Law makes the exclusion for employer payments of qualified education loans permanent and adjusts the maximum exclusion for inflation for tax years beginning after 2026. This applies to payments made after December 31, 2025. Enhancement of dependent care assistance programs: Under IRC Section 129, an employee may exclude from gross income certain amounts provided to them by their employer for dependent care assistance, as long as certain requirements are met. Under current law, the maximum amount excludible during a tax year under a dependent care assistance program was $5,000. The Law increases the amount excludible to $7,500, effective for tax years beginning after December 31, 2025. Bicycle commuting benefits: The Law terminates the exclusion from employee income for qualified bicycle commuting reimbursement under IRC Sections 132(a)(5) for tax years beginning after December 31, 2025. This exclusion has been suspended since 2018. The Law also removes the temporary exception from the commuting deduction disallowance under IRC Section 274(l) that was previously available for qualified bicycle commuting reimbursements. Deduction for moving expenses: The Law permanently repeals the deduction for moving expenses under IRC Section 217 (except for members of the Armed Forces, or their spouse or child, to whom IRC Section 217(g) applies). The Law also permanently repeals the qualified moving expense reimbursement exclusion under IRC Section 132 (except for members of the Armed Forces on active duty who move under a military order and incident to a permanent change of station). The deduction and the exclusion have been suspended since 2018. The Law adds a new exception from both the deduction and the exclusion for employees or new appointees of the intelligence community (as defined in section 3 of the National Security Act of 1947) moving pursuant to a change in assignment. The changes apply for tax years beginning after December 31, 2025. Enforcement provisions for COVID-related employee retention credits (ERCs): The ERC is a refundable federal employment tax credit, first enacted as part of the CARES Act in 2020, that was available for qualified wages paid by eligible employers during the COVID-19 pandemic from March 13, 2020, through September 30, 2021 (December 31, 2021, for recovery startup businesses). The statute of limitations expired on April 15, 2024, for claiming the 2020 credit, and on April 15, 2025, for claiming the 2021 credit. Many employers have claimed the ERC by filing a refund claim for the relevant quarter. As of July 4, 2025, the Law disallows refunds for the third and fourth quarters of 2021 if the claim was filed after January 31, 2024. Telehealth: The Law amends IRC Section 223 to make permanent an expired temporary provision that allowed pre-deductible coverage of telehealth services without disqualifying an otherwise eligible individual from making HSA contributions. Direct primary care service arrangements: The Law amends IRC Section 223 to clarify that an individual covered by a direct primary care service arrangement costing no more than $150 per month (doubled for family coverage) will not be disqualified from contributing to an HSA as a result of the direct primary care service coverage. This applies to months beginning after December 31, 2025. Bronze and catastrophic plans connected with HSAs: The Law amends IRC Section 223 to treat any bronze or catastrophic plan offered in the individual market on a health care exchange as a high-deductible health plan (HDHP). This applies to months beginning after December 31, 2025.
Document ID: 2025-1476 | ||||||
