U.S. States Deliberate Adoption of New Federal Tax Breaks on Tips, Overtime, and Business Equipment

Federal Tax Cuts Enacted

United States President Donald Trump signed the 'One Big Beautiful Bill' (OBBB) into law on July 4, 2025, introducing significant federal income tax deductions for qualified tips, overtime compensation, and business equipment. These provisions are effective for tax years beginning January 1, 2025, and are slated to run through December 31, 2028.

Under the new federal law, eligible employees in customarily tipped occupations can deduct up to $25,000 in qualified tip income. This deduction is available even for taxpayers who claim the standard deduction and phases out for those with a modified adjusted gross income exceeding $150,000 for single filers or $300,000 for joint filers. Similarly, non-exempt workers under the Fair Labor Standards Act (FLSA) can deduct up to $12,500 in qualified overtime pay, or $25,000 for joint filers, with similar income phase-out thresholds. For businesses, the legislation permanently allows a 100% write-off for new equipment placed into service after January 19, 2025. It is important to note that these deductions apply solely to federal income taxes, leaving federal payroll taxes (Social Security and Medicare) unaffected.

States Face Conformity Decisions

Following the federal changes, U.S. states are now grappling with whether to conform their state tax codes to these new federal provisions. The decision-making process varies by state: some states will automatically adopt the federal changes unless their legislatures explicitly opt out, while others require active legislative action to opt in. States that choose not to conform will see their residents pay no federal tax on these incomes but potentially still owe state taxes.

The potential financial implications for states are significant. While adopting the federal tax cuts could provide hundreds of millions of dollars in annual savings for residents and businesses, it could also financially strain state budgets. This strain is exacerbated by increased costs stemming from new Medicaid and SNAP food aid requirements also included in the federal bill. Most state legislative sessions commence in January, necessitating prompt action for any retroactive application to the 2025 tax year.

Early State Responses and Expert Commentary

As states begin to consider their options, initial responses have varied. Michigan has become the first state to opt into the tax breaks for tips and overtime wages, with the changes set to take effect in 2026. This move is projected to cost the state approximately $113 million for overtime and $45 million for tips during its current budget year, which Michigan lawmakers have offset by decoupling from certain federal corporate tax changes. Conversely, Colorado opted out of the state tax break for overtime even before the federal law was enacted.

Treasury Secretary Scott Bessent has urged states to conform to the new federal tax code, criticizing states like Colorado, New York, Illinois, and the District of Columbia for taking steps to eliminate conformity, arguing that non-conformity prevents residents from receiving corresponding state-level tax relief. However, tax policy experts express caution. Carl Davis, research director at the nonprofit Institute on Taxation and Economic Policy, noted that 'States in general are approaching this skeptically.' Jared Walczak, vice president of state projects at the Tax Foundation, advised lawmakers to 'consider whether these are worth the cost,' particularly given that the tip deduction, for example, might exclude numerous low-wage workers.

Looking Ahead

The Internal Revenue Service (IRS) released guidance on November 28, 2025, for the new tip and overtime deductions, and is expected to issue a list of eligible tip-receiving occupations by October 2, 2025. As state legislatures convene in the coming months, the debate over adopting these federal tax breaks is expected to be a central issue, balancing potential taxpayer savings against state fiscal health.