The One Big Beautiful Bill Act (“OBBBA”), approved by Congress and signed into law by President Trump on July 4, 2025, created a new, federal overtime tax deduction that employees can claim on their federal tax returns. The tax deduction applies retroactively to the beginning of 2025 and will terminate on December 31, 2028, unless extended.
The new tax deduction only applies to federally mandated overtime pay. Under the federal Fair Labor Standards Act (“FLSA”), non-exempt employees must be paid overtime pay at a rate of 1.5 times their “regular rate” of pay for all hours actually worked beyond a specified number within a designated work period, usually forty hours in a seven-day work period for non-safety employees.
The “regular rate” of pay required by the FLSA includes various items of compensation provided to an employee for services to the employer, beyond just the base rate of pay. Generally, unless an item of compensation is expressly excluded by statute, it must be included when calculating the overtime rate. Examples of items that must be included are longevity pay, education pay, certificate pay, and standby pay.
Because “qualified overtime compensation” under the OBBBA is determined by the FLSA, any non-FLSA overtime would not qualify for the deduction. Non-FLSA overtime is overtime such as overtime required solely by the California Wage Orders or contractual overtime under collective bargaining agreements. For example, the FLSA does not require daily overtime, (overtime paid for hours worked over eight in a workday), minimum call back time, extra pay for time worked on holidays, or overtime compensation paid to employees who are exempt from the overtime requirements. These premiums are often provided by collective bargaining agreements or personnel policies. Similarly, although the FLSA only counts hours actually worked towards the overtime threshold, many employers more generously count accrued paid time off as hours worked when calculating the overtime threshold.
Since employees are paid based on the more generous overtime rules adopted by the employer, employers’ payroll systems typically do not differentiate between overtime mandated under the FLSA and the more generous overtime calculation provided under the employer’s policy or bargaining agreements. Many employers have not tracked overtime required under the FLSA separately from non-FLSA overtime.
Since the new tax deduction only applies to FLSA overtime, employers must now separately track overtime required under the FLSA from overtime paid under more generous rules, but not mandated under the FLSA. Payroll systems will be required to track two types of overtime, rather than lumping all types of overtime together.
Starting with tax year 2025 W-2 forms, employers must track and report federal qualified overtime compensation separately so that eligible, non-exempt employees can claim a deduction for federal income tax when filing their federal income tax return.
Only overtime compensation paid to an individual required under the FLSA that is in excess of the regular rate is factored into the deduction amount. The Internal Revenue Service (“IRS”) has interpreted this provision to mean that only the half-time premium portion of time-and-a-half compensation qualifies for the deduction amount. For example, if an employee earns a regular rate of $40 an hour, their FLSA overtime rate would be $60 an hour ($40 x 1.5). Assuming the employee actually, physically worked a total of 50 hours in a seven-day work period, ten hours would be overtime under the FLSA and the employer would owe the employee a total of $600 in overtime pay. However, only $200 (i.e., the half portion in time-and-a-half) qualifies for deduction reporting purposes.
The OBBBA allows an individual whose modified adjusted gross income does not exceed $150,000 to take a maximum overtime deduction of $12,500. If individuals file a joint return and their modified adjusted gross income is less than $300,000, then the maximum overtime deduction is $25,000. The deduction is subject to an income-based phase-out if income exceeds these amounts.
For the 2025 tax year, employers are permitted to approximate a separate accounting of amounts designated as qualified overtime compensation by any reasonable method specified by the Secretary of the Treasury. The separate accounting method used should be documented and retained in the event of a future IRS audit.
Employers are required to report the total amount of qualified overtime compensation as a separate line item on a W-2 Form or any other specified statement furnished to the individual. Following the previous example, if an employee earns a total of $600 in overtime and only $200 qualifies for the deduction, then employers will need to implement a method that separately records only the overtime amount that qualifies (i.e., the $200).
The IRS has also stated that it will provide transition relief for employers. Because the Secretary of Treasury and the IRS have yet to provide official guidance, W-2 Forms and other payroll forms, and federal income tax withholding tables will remain unchanged for the 2025 tax year.
Employers can expect the IRS to provide withholding procedures for the taxable years following December 31, 2025. For the 2026 tax year, the IRS published a draft W-2 with instructions for employers to use the code “TT” in Box 12 to report qualified overtime compensation. However, this draft W-2 is for next year and not for 2025 reporting. The IRS and the Treasury Department are expected to provide additional guidance for both reporting entities and individual taxpayers.
Previously, different rates of pay for different types of overtime may not have been practical for payroll purposes. However, new federal overtime tracking requirements have changed the landscape in regard to different pay rates. While the FLSA mandates overtime pay at an employee’s regular rate of pay, if a public agency negotiates to pay contractual overtime above and beyond FLSA requirements, payment of the regular rate is not required for non-FLSA overtime. Public agencies looking to save money can consider adopting a straight time rate, 1.5 times base pay, or even 1.5 times minimum wage rather than using the higher regular rate to calculate non-FLSA overtime. Such changes would be subject to meet and confer requirements for represented employees.
Employers must review their practices and agreements related to the payment of overtime. Employers must isolate and determine which overtime is required under the FLSA and which overtime is based on state, local, or contract provisions not mandated by the FLSA. For example, overtime paid for working on holidays, overtime based on the inclusion of paid leaves, and minimum call back time at the overtime rate that does not qualify as overtime under the FLSA must be tracked separately from overtime required under the FLSA.
LCW recommends that agencies continue to follow guidance from the Secretary of Treasury and the IRS to navigate new reporting requirements for the current and future years. Agencies should begin taking steps to identify and isolate overtime required under the FLSA.
Trusted legal advisors can assist with questions about compliance with the new federal overtime deduction and identifying FLSA mandated overtime.