The payroll tax changes in President Trump’s 2025 legislation—commonly called the One Big Beautiful Bill Act (OBBB) — could have a major impact on your business and employees. Signed into law on July 4, 2025, the OBBB includes a variety of payroll-related tax changes — some permanent, others temporary. Here’s what employers need to know:
1. Enhanced Enforcement for COVID-Related Employee Retention Credits
The Employee Retention Credit (ERC) was created in March 2020 to help employers keep workers on payroll during the pandemic. The credit ended for most employers in Q3 2021, but amended payroll tax returns for prior years could still be filed into 2024 and 2025. As the program wound down, the IRS saw a surge in questionable claims from “ERC mills”—businesses promoting the credit without properly verifying eligibility.
- Promoter Penalties – ERC Promoters who fail to meet certain due diligence standards face a $1,000 penalty per failure. A promoter is defined by revenue thresholds (e.g., ERC revenue greater than 20% of gross receipts and $500,000 total), with aggregation rules across related entities. Certified Professional Employer Organizations (CPEOs) are excluded.
- Hard Claim Deadline – No new ERC claims may be filed after Jan. 31, 2024; any filed later are automatically denied.
- Extended Audit Period – The IRS now has six years (previously five) to assess ERC-related employment taxes, measured from the latest of the return filing date, deemed filing date, or claim date. The same extended period applies to wage deduction adjustments tied to disallowed credits; employers whose credits may be denied should consider a protective refund claim to preserve the wage deduction.
- Expanded Erroneous Refund Penalty – A 20% penalty for “excessive” refund claims now applies to employment tax refunds, unless reasonable cause is shown.
Employers should conduct a thorough review of any ERC claims to confirm eligibility, documentation and compliance. These provisions are effective July 4, 2025.
2. No Tax on Tips
The OBBB creates a new deduction for certain tip income. This change is effective for taxable years beginning after Dec. 31, 2024, and applies only for calendar years 2025 through 2028. Key points include:
- Deduction Amount – Up to $25,000 annually of qualified tips may be deducted. Qualified tips are voluntary cash or charged tips in an occupation that the IRS determines “customarily and regularly” received tips on or before Dec. 31, 2024.
- Eligibility – Available to both itemizers and non-itemizers. Deduction phases out by $100 for every $1,000 of modified adjusted gross income above $150,000 ($300,000 for joint filers). Married taxpayers must file jointly, and a valid Social Security number is required.
- Industry Exclusions – Not available to workers in a Specified Service Trade or Business described in the Internal Revenue Code (IRC) § 1202(e)(3)(A) (without the words “engineering or architecture”).
- Payroll Practices
- Current Year – For 2025, tips remain subject to federal income tax withholding as well as FICA (Social Security and Medicare taxes) and FUTA (Federal Unemployment tax) where applicable. The deduction is claimed by the employee on their federal income tax return, not through payroll. Federal income tax withholding tables will not be updated for the new tips deduction this year.
- Future Years – The IRS will update withholding tables and procedures in 2026 to account for the deduction of qualified tips. Although qualified tips will likely be excluded for federal income tax withholding purposes, they remain subject to FICA and FUTA where applicable. Employees still must claim the deduction on their income tax return.
- Reporting
- Current Year – For 2025, employers and payors must continue reporting all tips as wages on Forms W-2, 941 and 940 and as nonemployee compensation on Form 1099. The IRS will not update these forms to include line items for qualified tips until at least 2026. In the meantime, employers should use reasonable methods to track qualified tips and the service provider’s occupation.
- Future Years – For 2026, it is expected that the IRS will revise payroll forms to include a specific box or code for qualified tips.
- Guidance: By Oct. 2, 2025, the IRS must publish a list of occupations that “customarily and regularly” received tips on or before Dec. 31, 2024.
- Employer FICA Tip Credit Expansion – Employers previously could claim a federal income tax credit for their share of FICA taxes on employee cash tips but only in food and beverage businesses. The OBBB permanently expands this credit to include beauty and personal care establishments where tipping is customary.
3. No Tax on Overtime
For tax years 2025 through 2028, certain overtime pay will qualify for a special, above-the-line deduction.
- Deduction Amount – Up to $12,500 annually ($25,000 for joint filers) of qualified overtime compensation may be deducted. This means the portion of pay that exceeds the employee’s regular rate of pay, as required under the Fair Labor Standards Act (FLSA), excluding any amounts already treated as qualified tips.
- Eligibility – Available to both itemizers and non-itemizers. Deduction phases out by $100 for every $1,000 of modified adjusted gross income above $150,000 ($300,000 for joint filers). Married taxpayers must file jointly, and a valid Social Security number is required.
- Payroll Practices
- Current Year – For 2025, qualified overtime remains subject to federal income tax withholding, FICA and FUTA where applicable. The deduction is claimed by the employee on their federal income tax return, not addressed through payroll. Federal income tax withholding tables will not be updated for the new overtime deduction this year.
- Future Years – In 2026, the IRS is expected to update withholding tables and payroll procedures to reflect the new deduction for qualified overtime compensation. Although qualified overtime will likely be excluded for federal income tax withholding purposes, it will remain subject to FICA and FUTA where applicable. Employees still must claim the deduction on their income tax return.
- Reporting Requirements
- Current Year – For 2025, employers must continue reporting all overtime as wages on Forms W-2, 941 and 940. The IRS will not update these forms to include line items for qualified overtime until at least 2026. In the meantime, employers should use reasonable methods to track qualified overtime and maintain documentation supporting it meets the standard for eligibility.
- Future Years – In 2026, it is expected that the IRS will revise Form W-2 and other forms to include a specific box or code for qualified overtime.
4. Extension and Enhancement of Paid Family and Medical Leave Credit
The OBBB expands and makes permanent the employer tax credit for providing paid family and medical leave, which credit was previously scheduled to expire after 2025.
- Credit Base Expansion – The credit is now available for either (1) wages paid directly by the employer to an employee for qualifying leave, or (2) premiums paid by the employer to an insurer or similar provider that pays the employee for qualifying leave.
- Revised Aggregation Rules – The OBBB aligns the employer aggregation rules with IRC §§ 414(b) and 414(c). Employers may avoid aggregation only by showing a “substantial and legitimate business reason” to the IRS. Differences in business lines, wages, job categories or state/local leave laws are expressly excluded as valid reasons.
- Employee Eligibility Expanded – “Qualifying employees” now include part-time employees who work at least 20 hours per week and meet the service requirement (which can now be as little as six months, at the employer’s election, instead of one year).
- Interaction with State or Local Paid Leave – The OBBB now allows state or local mandated paid leave to count toward meeting the eligibility thresholds—such as the minimum two-week leave period and the 50% wage replacement rate—if covered by the employer’s written policy. However, the credit applies only to employer-paid amounts exceeding state or local requirements.
- Effective Date – These changes apply to taxable years beginning after Dec. 31, 2025.
5. Enhancement of Employer-Provided Child Care Credit
The OBBB significantly expands the nonrefundable tax credit under IRC § 45F for employer-provided childcare.
- Higher Credit Rates and Limits – The credit rate for “qualified childcare expenditures” increases from 25% to 40% for most employers and to 50% for an eligible small business. The annual cap on total creditable expenses rises from $150,000 to $500,000 (or $600,000 for eligible small businesses). Beginning in 2027, these dollar limits will be indexed for inflation.
- Expanded Eligibility for Qualified Expenses – In addition to direct spending on an on-site or near-site facility, qualified expenses now include:
- Third-party Intermediary Arrangements – Employers may now contract with outside organizations to secure and manage childcare spaces with licensed providers. Payments for arranging and maintaining these spaces, whether at on-site, near-site or community facilities, now qualify for the credit under the OBBB.
- Jointly Owned or Operated Facilities – Employers sharing a qualifying childcare facility may now claim the credit for their proportionate expenses, provided the facility meets all requirements.
- Small Business Definition Change – For purposes of the enhanced 50% rate and higher cap, the “small business” gross receipts test now looks to an average over five taxable years (instead of three).
- Effective Date – The changes apply to amounts paid or incurred after Dec. 31, 2025.
6. Permanent Exclusion for Employer Student Loan Payments
The OBBB makes two targeted changes to the rule in IRC § 127 that allows employer payments toward an employee’s student loans to be excluded from income:
- Permanency – The temporary COVID-era provision, previously set to expire after 2025, is now permanent.
- Inflation Indexing – The $5,250 annual limit will be indexed for inflation starting in tax years after 2026, rounded to the nearest $50.
All other requirements remain the same.
Effective Date – The changes apply to amounts paid after Dec. 31, 2025.
7. Increased Dependent Care Assistance Program Limit
The OBBB amends IRC § 129 to permanently raise the annual limit on employer-provided dependent care assistance that employees can exclude from income. For taxable years beginning after Dec. 31, 2025, the exclusion increases from $5,000 to $7,500 for most taxpayers (and from $2,500 to $3,750 for married individuals filing separately).
All other requirements remain the same.
8. Elimination of Qualified Bicycle Commuting Reimbursement
The OBBB permanently ends the $20 monthly tax-free exclusion for bicycle commuting reimbursements under IRC § 132(f), previously suspended for years 2018-2025. It also changes the inflation adjustment base year for other qualified transportation fringe benefits from 1998 to 1997.
The OBBB introduces sweeping payroll-related tax changes that will affect employer compliance, employee compensation, and reporting practices for years to come. Employers should carefully review these provisions, update internal procedures, and ensure proper documentation to maximize benefits and avoid penalties. For guidance tailored to your specific circumstances, you can contact Parsons Behle & Latimer for assistance.
