IRS Issues New Guidance on Qualified Overtime Compensation Deductions

The following article first appeared in the News & Insights section of Carmody Torrance Sandak Hennessey’s website. It is reposted here with permission.

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Key Takeaways for Employers

• Only FLSA-required overtime qualifies for the federal income tax deduction. The deduction generally applies only to the additional “half” of time-and-a-half overtime required by the FLSA and excludes overtime or premium pay required solely by state law, contract, or employer policy. 
• Continue normal tax withholding, rather than adjusting for anticipated overtime deductions. Qualified overtime remains subject to federal income tax withholding, Social Security, and Medicare taxes. Employers should not automatically reduce the withholding because an employee may qualify for the deduction. 
• Prepare for new 2026 reporting requirements. Employers must separately report qualified overtime compensation on Form W-2 using Box 12, Code TT and qualified tips using Code TP. 
• Review payroll systems now. Employers should ensure their systems can accurately identify and separately track FLSA-qualified overtime and coordinate with payroll providers on the new reporting requirements. 

On Aug. 6, 2026, the Internal Revenue Service issued updated Frequently Asked Questions concerning the new federal income tax deduction for qualified overtime compensation under the One, Big, Beautiful Bill Act.

This deduction is only available for tax years 2025 through 2028.

The FAQs supersede the previously released FAQs and provide important clarification concerning what qualifies for the deduction and employers’ payroll and reporting obligations.

‘No Tax on Overtime’ Does Not Mean Overtime Is Tax-Free

For tax years 2025 through 2028, eligible employees may claim a federal income tax deduction for “qualified overtime compensation.”

This deduction applies only to the portion of overtime compensation required under the Fair Labor Standards Act that exceeds the employee’s regular rate of pay—that is, the “half” portion of the “time and one half” amount they receive as overtime pay. 

The FAQs underscore that overtime pay that is not required under the federal FLSA is not eligible for deduction.

Overtime pay that is not required under the federal FLSA is not eligible for deduction.

Therefore, premium or overtime pay that may be required by policy, contract, or even state law, but is not required under the FLSA, does not qualify for the federal deduction.

As such, the deduction is only available to non-exempt employees; employees who qualify for an overtime exemption, such as executive, administrative and professional employees, are not eligible for the deduction. 

The FAQs also clarify that business owners holding 20% or greater equity who participate in management are classified as exempt executive employees under the FLSA and cannot claim the deduction.

The maximum deduction is $12,500 per year and $25,000 for married taxpayers filing jointly. The deduction is reduced if a taxpayer’s modified adjusted gross income for the tax year exceeds $150,000 or $300,000 for joint filers.

Employers Must Withhold Federal Income Taxes

The updated FAQs expressly state that overtime compensation remains fully subject to federal income tax withholding, including Social Security and Medicare taxes.

Employers should not reduce the withholding simply because an employee may ultimately qualify for the overtime deduction.

However, the FAQs state that an employee may submit a properly completed and valid Form W-4 reflecting the anticipated deduction.

If this occurs, employers may then adjust withholding consistent with the updated Form W-4.

New W-2 Reporting Requirement for 2026

Employers were not required for the 2025 tax year to include qualified overtime compensation or qualified tips on year-end tax forms, such as Form W-2s.

However, the FAQs state that beginning with the 2026 tax year, employers must separately report “qualified overtime compensation” on Form W-2, using Box 12, Code TT, and qualified tips on using Code TP.

Beginning with the 2026 tax year, employers must separately report “qualified overtime compensation.”

Qualified overtime compensation paid to certain workers reported on Forms 1099-MISC or 1099-NEC is subject to similar reporting requirements.

Employees cannot claim a tax deduction exceeding the amount reported on their Form W-2.

As such, the FAQs state that if an employee believes that an employer omitted or understated qualified overtime, the employee must request a corrected Form W-2c before claiming the deduction.

What Employers Should Do

Employers should understand what constitutes qualified overtime compensation, confirm that their payroll systems can accurately identify and separately track the overtime compensation that qualifies for the deduction, and coordinate with payroll providers concerning the new Form W-2 reporting requirements.

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About the author: Nick Zaino is a partner at Carmody and co-leader of the firm’s Corporate & Business Group.