IRS Provides Clarity on Overtime Deduction Reporting for Employers

Beginning this year, employers must report certain overtime paid to employees who may be eligible for a new federal income tax deduction. The One Big Beautiful Bill Act (OBBBA) introduced the deduction for qualified overtime compensation of up to $12,500 annually ($25,000 for married couples filing jointly) for 2025 through 2028. Employers that pay overtime should understand the deduction’s requirements and potential payroll implications. Recently updated IRS FAQs provide additional guidance on the rules and employers’ responsibilities.

How the Overtime Deduction Works

Eligible employees with qualifying overtime pay can claim the overtime deduction even if they claim the standard deduction rather than itemizing deductions on their federal tax returns. But this break doesn’t reduce their adjusted gross income (AGI). Also, federal payroll taxes still apply, and this income may be fully taxable for state and local income tax purposes.

The overtime deduction begins to phase out when an employee’s modified AGI (MAGI) exceeds $150,000 ($300,000 for joint filers). In this context, MAGI consists of a taxpayer’s regular AGI plus certain tax-free offshore income (which typically doesn’t apply). The deduction phases out in $100 increments for each $1,000 of MAGI, or a portion thereof, exceeding the applicable threshold.

Certain other rules also apply to eligible employees. For example, if married, they must file a joint return to claim the deduction. Also, eligible employees must have a Social Security number valid for employment that the Social Security Administration issued by the due date of their return, including extensions. The Social Security number must appear on the return claiming the deduction.

Defining “Qualified Overtime Income”

The overtime deduction applies only to qualified overtime income, which is defined as extra compensation paid in compliance with the Fair Labor Standards Act (FLSA). The law generally requires time-and-a-half pay for worktime exceeding 40 hours in a workweek. We’ll refer to these extra “half” amounts as overtime “premiums.”

For example, let’s say one of your employees, Lisa, worked 20 hours of overtime in the most recent pay period. Under the FLSA, you paid her $37.50 per hour for overtime compared to her regular hourly rate of $25. In this scenario, Lisa’s hourly overtime premium is $12.50 ($37.50 − $25), and her qualified overtime income for the period is $250 (20 × $12.50).

Qualified overtime income doesn’t include overtime paid to FLSA-exempt employees, such as executives. It also excludes overtime not required by the FLSA but mandated by state law or under certain contracts (for example, union-negotiated collective bargaining agreements). In other words, the overtime deduction is unavailable to employees who aren’t subject to the FLSA’s overtime pay requirements.

IRS Guidance Clarifies the Rules

Here are some highlights of the updated IRS FAQs:

Mandatory reporting requirement. Starting in 2026, employers must separately report qualified overtime income on employees’ Forms W-2 using Box 12 and Code TT. Employees can deduct only the qualified income amounts that are reported on their W-2s.

If an error is discovered, employers must issue Form W-2c to the affected employee. Failure to promptly correct reporting errors may expose an organization to IRS penalties. In addition, if qualified overtime is omitted or understated and an employer doesn’t provide a corrected W-2, the employee generally can’t claim the unreported amount as part of the deduction.

Qualified overtime income calculation. For the deduction’s purposes, qualified overtime income generally equals hours worked in excess of 40 during the FLSA-defined workweek × the employee’s FLSA-mandated regular pay rate × 50%.

Only the overtime premium (the extra 50%) qualifies for the deduction. The recently issued FAQs confirm the link between the overtime deduction and existing FLSA rules for:

• Workweek determinations,
• Hours worked calculations,
• FLSA-mandated regular rate of pay calculations, and
• Allowable alternative overtime calculation methods.

Employers may need to update payroll systems to add qualified overtime income data to other information they’re already tracking for, say, state law overtime pay compliance, collective bargaining agreements or employer-specific overtime premiums.

FLSA exemptions. The updated IRS guidance reiterates that only FLSA-required overtime premiums can qualify for the overtime deduction. Employees who are exempt from the FLSA overtime rules are ineligible for the deduction — regardless of whether they’re eligible for overtime-like payments under employer-specific policies, state law or collective bargaining agreements.

The IRS guidance specifically highlights several common exempt categories. These include executives, administrative personnel, some types of “professional” employees, outside sales personnel, and certain IT and commissioned retail employees. Employee-owners who hold at least a 20% ownership interest and who are actively engaged in management are generally treated as exempt executives. Therefore, they’re ineligible for the overtime deduction.

Non-FLSA overtime. The updated guidance clarifies that employers must distinguish between FLSA-required overtime and other overtime payments that they pay voluntarily or under other legal requirements. For instance, overtime premiums for weekend or holiday work and double-time arrangements may exceed FLSA requirements. When they do, only the amount needed to satisfy the FLSA overtime requirement counts as qualified overtime income. Any excess amount doesn’t increase the employee’s allowable overtime deduction.

Differences between FLSA-required overtime and state-law overtime requirements may confuse employees and create payroll system challenges for employers. For example, some employees may be subject to FLSA overtime pay exemptions that don’t have comparable exemptions under state law. Employers must independently evaluate whether staff members are exempt from overtime under the FLSA even though they may be eligible under state law.

Federal income tax withholding. The FAQs confirm that qualified overtime income remains subject to federal income tax withholding. Employers generally can’t reduce withholding unless an employee submits an updated Form W-4 that reflects the individual’s anticipated overtime deduction.

Consider reminding employees who may be eligible for the overtime deduction to review the accuracy of their current W-4s. Employees who withhold too little could face a larger-than-expected tax bill when they file their tax returns. Conversely, those who withhold too much risk unnecessarily lowering their take-home pay. The IRS updated the 2026 W-4 to allow employees to account for the overtime deduction.

Are You Ready for 2026 Reporting Requirements?

The IRS’s updated guidance highlights the importance of accurately tracking and reporting qualified overtime compensation. Review your payroll systems and procedures to determine whether you need changes to meet applicable requirements. We can help ensure compliance and make any necessary adjustments to your payroll practices.

© 2026