What the Updated Overtime Deduction Rules Mean for Your Payroll
The overtime deduction created by the One Big Beautiful Bill Act has been on the books for a while now, but until recently the guidance on how employers actually report it was thin. That changed in August, when the IRS substantially expanded its frequently asked questions on the deduction for qualified overtime compensation.
The updated FAQs supersede the guidance issued in January, which we covered earlier this year when the IRS released fact sheets on electronic payments and the overtime deduction.
The new version adds real operational detail: how to report qualified overtime on Form W-2, how withholding works, how to fix errors, and which workers are eligible in the first place. If you run payroll for hourly employees, there's something here that affects your January W-2s.
The reporting change to plan for now
Beginning with tax year 2026, employers must separately report qualified overtime compensation on Form W-2, box 12, using code TT.
That single requirement carries more weight than it might appear to. Under the updated guidance, employees generally can only claim the deduction for amounts that show up in that box. And if the amount is understated, the employee can't fix it unilaterally — the IRS specifically addressed this, stating that a worker may not use Form 4852, the substitute for Form W-2, to claim additional deductible overtime that wasn't reported. The only route is a corrected form from the employer.
The amount you report is the full amount of qualified overtime compensation paid during the year. You don't reduce it because a particular employee's income will phase them out of the deduction or because they'll hit the annual cap. Report the full figure and let the deduction limits get applied on the individual's return.
If you discover an error in what was reported, you'll need to file Form W-2c and furnish the corrected form to the employee. On the employee's side, obtaining that corrected W-2 is a prerequisite to claiming a larger deduction.
This is the part worth flagging to whoever runs your payroll: getting code TT right the first time avoids a correction cycle that runs through the middle of filing season.
A deduction, not an exemption
One point the IRS was explicit about: the deduction doesn't remove overtime pay from gross income.
Overtime compensation remains subject to federal income tax withholding and employment taxes, including Social Security and federal unemployment tax. Eligible employees claim the benefit as a deduction on their return, within statutory limits and subject to income-based phaseouts.
That distinction matters at the payroll level. Employers must continue withholding federal income tax from overtime wages as usual and may not reduce withholding on their own initiative because an employee is expected to qualify for the deduction. If an employee wants their withholding adjusted to reflect the deduction, the mechanism is an updated Form W-4, not an informal request to payroll.
The limits
Eligible taxpayers can deduct up to $12,500 of qualified overtime compensation per year, or up to $25,000 on a joint return. The deduction begins phasing out once modified adjusted gross income exceeds $150,000 for single filers or $300,000 for joint filers.
It's also worth remembering what "qualified overtime compensation" means, since it's narrower than most people assume. The deduction applies to overtime required under the Fair Labor Standards Act, and generally only to the premium portion, which is the amount above the employee's regular rate of pay, not the entire overtime payment. For time-and-a-half, that's the half, not the whole.
Who's actually eligible
The updated FAQs expanded considerably on eligibility, largely by walking through FLSA coverage.
Workers exempt from the FLSA's overtime requirements aren't eligible for the deduction. The IRS listed several categories that may fall into that group, including certain executive, administrative, professional, outside sales, computer, agricultural, transportation, and seasonal employees.
A new FAQ addresses employee-owners specifically, and this one is relevant to a lot of closely held businesses in our area. An employee who holds at least a bona fide 20% equity interest in a business and is actively engaged in managing it is generally exempt from the FLSA's overtime requirements, and therefore is not eligible for the deduction.
The guidance also gets into the mechanics of calculation: workweeks, hours worked, regular-rate computations, alternative methods for computing overtime, and compensatory time arrangements available to some state and local government employees. There's an expanded section for federal employees as well, covering FLSA eligibility, work periods, and regular-rate calculations under Office of Personnel Management rules. The IRS said it coordinated the update with the Department of Labor and OPM.
What to do before January
For most employers, the practical work is short and worth doing before year-end rather than during it:
Confirm your payroll system can identify and separately track qualified overtime compensation, and that it will populate box 12, code TT on the 2026 W-2.
Verify how your system distinguishes the premium portion of overtime from the base portion, since only the premium counts.
Review which of your employees are FLSA-exempt, and check whether any employee-owners are being treated correctly under the 20% equity rule.
Leave your withholding process as it is, and be ready to answer employees who ask about adjusting theirs. Point them to Form W-4.
Payroll systems generally handle this once configured, but "generally" is doing some work in that sentence, especially for businesses using older software or handling payroll in-house. The time to find a gap is now, not in the last week of January.
Questions?
If you're not certain your payroll setup will report qualified overtime correctly, or you have questions about how the deduction applies to your employees or to owner-employees in your business, contact us - we can help you sort it out well ahead of W-2 season.
HFM CPAs provides specialized accounting, tax, and assurance services to individuals and businesses across Connecticut and Rhode Island.
