The One Big Beautiful Bill's Overtime Tax Deduction

Preparing for Employer Obligations & Employee Communications

Summary

Under the One Big Beautiful Bill Act, employers must identify and report by January 31, 2026 the FLSA-required portion of employee overtime pay for the entire 2025 calendar year. This obligation introduces new compliance and communication challenges for employers and payroll teams who will be required to reconfigure earnings codes, classify overtime sources, validate regular-rate calculations, and prepare clear employee communications to correct misperceptions and manage employee expectations.

Background

Under the federal Fair Labor Standards Act (FLSA), non-exempt employees are entitled to time-and-a-half pay for all hours worked over 40 in a single workweek. The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, introduces a groundbreaking federal tax deduction for many working Americans: up to $12,500 of "Qualified Overtime Pay" earned in 2025 is exempt from federal income tax ($25,000 for joint filers). The deduction is available to both itemizing and non-itemizing taxpayers but begins to phase out for taxpayers with modified adjusted gross income over $150,000 ($300,000 for joint filers). Notably, the deduction only applies to federal income tax; employees will continue to pay Social Security and Medicare taxes, as well as applicable state income taxes, on all overtime earnings.

Effective through tax year 2028, the new tax deduction imposes significant compliance obligations on employers, requiring them to identify and report Qualified Overtime Pay earned since the beginning of 2025 on employee W-2s (or other applicable tax documents) albeit with some penalty leniency for the first reporting year, as noted below.

What Is "Qualified Overtime Pay"?

The deduction applies only to the "half" portion of time-and-a-half overtime pay under the FLSA. For example, if an employee works 50 hours in a workweek at a regular rate of $20/hour, the Qualified Overtime Pay that can be deducted would equal $100 (0.5 overtime increment x $20 regular rate of pay x 10 hours of overtime = $100). The deduction would not include the straight time portion of the overtime hours ($20 regular rate x 10 hours).

Overtime pay that is required pursuant to state law, a collective bargaining agreement (CBA), or company policy — but not under the FLSA —does not expressly qualify for the tax deduction (clarity on this will likely be provided in subsequent promised IRS guidance).

New W-2 Reporting Obligations

Starting January 31, 2026, employers must separately identify and report the FLSA-required portion of overtime pay that qualifies for the deduction. This represents a significant departure from past practice, as tax forms previously did not require employers to separate regular and overtime pay, and most employers currently report overtime on pay stubs only as hours worked and a single lump sum without distinguishing whether it was federally required.

While employers will be required to report Qualified Overtime Pay on a revised Form W-2 beginning in tax year 2026, the IRS has encouraged employers to include this information in Box 14 of the employees' 2025 W-2s or in a separate written statement for tax year 2025. On November 5, 2025, the IRS and Treasury Department issued guidance providing penalty relief related to the new OBBBA reporting requirements and indicated that additional information about the deduction will be released in future guidance.

The Overtime Basis Challenge

Many employers pay overtime for reasons not required under the FLSA, such as:

• Daily overtime pay — required under certain circumstances by state law when employees work more than a set number of hours in a day. Alaska, California, Colorado, Nevada, Oregon, and Puerto Rico are examples of jurisdictions that have such laws.
• Overtime pay required by CBAs — many CBAs mandate overtime pay for union-represented employees who work more than a set number of hours per day or perform work on weekends/holidays.
• Voluntary overtime or incentive pay — includes employer-initiated incentives for employees classified as exempt under the FLSA (and thus not required to be paid for overtime), or when an employer counts time as "worked" even when not required by the FLSA.

Until now, employers have not had to distinguish on tax forms any FLSA-required overtime from other overtime or even straight time compensation. That's changing. With the January 31, 2026 reporting deadline for 2025 wages rapidly approaching, employers have little time to sort, calculate, and report the deductible portion accurately. The IRS will allow employers to request a 30-day extension of this deadline and has stated that it will not penalize initial reporting errors, but it still expects employers to provide accurate reporting.

Managing Employee Expectations Through Clear Communication

During the 2024 election cycle, candidates from both major political parties pledged "no tax on overtime." The realities of the legislative process, however, produced a narrower result. Most employees are likely unaware that the law passed in July 2025 differs from what many perceived was promised.

Employees may already be anticipating substantial tax refunds tied to the OBBBA overtime deduction, especially since employers have already withheld federal taxes on eligible overtime throughout 2025. In practice, however, it is very likely that pay stubs may not align with the amounts ultimately reported for tax purposes, leading to employee confusion.

For example, an employee who received overtime pay for working a holiday pursuant to employer policy —but whose total hours that workweek did not exceed 40 — would not qualify for the deduction based on those reported overtime hours. Similarly, an employee who worked 50 hours in a workweek and was entitled to a deduction would only be eligible for a tax deduction on the "half" rate paid for 10 hours (not the totality of the overtime pay).

A clear communication strategy will be essential for employers to manage employee expectations and explain the difference between overtime generally and the FLSA-qualified overtime that is eligible for the deduction.

Emerging Legal and Compliance Risks

In addition to proper overtime calculation and classification, increased scrutiny of overtime pay may prompt employees to question other wage and hour issues, such as:

• How the regular rate of pay is calculated – the FLSA's complex rules about what is included in this calculation will now, for the first time, affect which portion of overtime pay qualifies for the deduction, and, accordingly, may prompt closer employee review.
• Whether employees are properly classified as exempt or non-exempt – certain exempt employees may find that, after taxes, they take home less than their non-exempt peers and request reclassification.
• Whether timekeeping practices fully comply with all applicable wage and hour laws – employees may be more attentive to how their hours are tracked and classified, seeking to maximize the time that qualified for the new tax-deductible overtime category.

This heightened employee awareness may also draw increased scrutiny by regulators and, in turn, increase the risk of costly wage-and-hour litigation. This risk may be particularly acute in private collective actions, where employer exposure can be escalated by attorney fee-shifting (allowing prevailing employee plaintiffs to recover reasonable attorney fees and costs) and statutory penalties, such as liquidated damages equal to back wages and DOL civil monetary penalties.

How Employers Can Prepare

To navigate these challenges, employers can consider taking the following actions:

• Ensure detailed records of overtime hours are kept to document payments pertinent to employees' eligible tax deductions under the OBBBA.
• Implement separate tracking for qualified overtime to identify FLSA-required hours.
• Consult with legal counsel experienced in wage-and-hour issues, especially the FLSA, to ensure employees are accurately classified and FLSA-required hours are appropriately categorized.
• Train payroll staff on the new requirements and deadlines.
• Coordinate with payroll vendors to ensure compliance as to any outsourced services.
• Before employees voice concerns, develop employee communications to explain your compliance with the new reporting requirements on "Qualified Overtime Pay" and coordinate comms with HR staff who are likely to be fielding employee inquiries.
• Refer employees to their own tax advisors for specific assistance as to tax deductions and/or potential refunds.
• Track any additional IRS guidance on OBBBA in the coming months.

The OBBBA offers a meaningful overtime tax break for employees, but it also requires rigorous compliance and proactive communication from employers. With the right preparation, employers can turn this challenge into an opportunity to reinforce trust and transparency with their workforce. If you would like to consult on wage-and-hour issues or other employment law matters, please contact Patricia Lantzy (plantzy@outsidegc.com), who leads OGC's Employment, Labor & Immigration practice and can connect interested employers with experienced counsel, including co-authors Anne Di Salvo (adisalvo@outsidegc.com) or Doug Graham (dgraham@outsidegc.com).