The Overtime Tax Deduction Gets Real: What Public Agencies Need to Know About the IRS’s New Guidance

On August 6, 2026, the IRS issued Fact Sheet FS-2026-13, providing its most detailed guidance yet about the One Big Beautiful Bill Act’s (OBBBA) tax deduction for qualified overtime compensation. The new Fact Sheet identifies frequently asked questions and provides answers related to the deduction. For public agencies, the message is clear: 2026 payroll systems, overtime classifications, and W-2 reporting deserve a closer look now—not next January when reporting is due.

What is Qualified Overtime Compensation (QOC) for the Tax Deduction?

QOC is the amount of overtime compensation required under Section 207 of the FLSA that is in excess of a non-exempt employee’s regular rate of pay. Generally, QOC that is subject to the deduction is the “one-half” (0.5) portion of the time and one-half (1.5) paid to a non-exempt employee for overtime hours worked under the federal Fair Labor Standards Act (FLSA). For more information on the basics, see LCW’s prior blog post about the deduction.

The Key Question: Is the Overtime Required by the FLSA?

This is where public agencies need to pay particular attention. The IRS makes clear that the deduction applies only to overtime compensation required under Section 7 of the FLSA. Overtime paid solely because of a memorandum of understanding, a collective bargaining agreement, or an agency’s own policy does not qualify.

Comp Time Off Creates Another Wrinkle

Public agencies also should take note of the IRS’s guidance concerning compensatory time off (CTO). As described in LCW’s prior blog post about the OBBBA and CTO, the FLSA permits public agencies to compensate employees for FLSA overtime in the form of CTO, subject to an agreement and certain conditions and limitations. When an employee chooses to accrue CTO in lieu of overtime pay in cash, each hour of FLSA overtime worked is credited with one and one-half hours of CTO in the employee’s CTO bank. The employee may then use their CTO hours as paid time off in the future or may cash out CTO hours that go unused at the regular rate of pay upon separation (or at other times based on the terms in an MOU or other agreement).

The IRS specifies that CTO is only reported when hours are used or cashed out, not when CTO hours are earned and banked for future use. A CTO payment can be provided when an employee takes time off using their accrued CTO hours or otherwise cashes out unused CTO hours. The IRS provides specific formulas for determining the qualifying amount.

IRS Notice 2025-69 provides the following example illustrating how to take a CTO payment and calculate the reportable QOC amount:

Example 6. Individual D works for a State or local government agency that gives compensatory time at a rate of one and one-half hours for each overtime hour worked under 29 USC 207(o). In 2025, Individual D was paid wages of $4,500 with respect to compensatory time off taken in accordance with section 207(o). For purposes of determining the amount of qualified overtime compensation received in tax year 2025, Individual D may include $1,500, one-third of these wages for purposes of determining qualified overtime compensation under section 225(c).

The following is an example of how a CTO cash out payment is reported as QOC:

CTO Cash Out Example: Mary works for a local government agency that gives compensatory time at a rate of one and one-half hours for each overtime hour worked under 29 USC 207(o). In the tax year, Mary did not take any paid time off using CTO, but pursuant to an applicable memorandum of understanding, Mary was able to cash out $6,000 of unused CTO hours. Mary may include $2,000, which is one-third of the CTO cash out payment, for purposes of determining qualified overtime compensation under section 225(c).

For agencies with employees who have significant comp-time balances, this could create an important timing issue for payroll and year-end W-2 reporting.

W-2 Reporting Is No Longer Optional

Perhaps the most immediate operational change is the enforcement of the reporting requirement.  The transition relief from 2025 that made it optional for employers to report QOC is no more. Beginning with tax year 2026, employers must report QOC for non-exempt employees on Form W-2 using Box 12, Code TT.

Importantly, the amount reported is the total QOC paid—not necessarily the amount the employee ultimately may deduct. Employers are required to report the full amount of QOC the employee received regardless of the deduction cap.  For example, an employee could have $30,000 of QOC reported in Code TT even though the OBBBA caps the amount of the overtime deduction at $12,500 ($25,000 for joint filers) and limits the deduction if the employee’s modified adjusted gross income (“MAGI”) is over $150,000 ($300,000 for joint filers). The deduction is phased out by $100 for every $1,000 of MAGI above $150,000 ($300,000 for joint filers).  See LCW’s article about the deduction cap for more information.

Report Qualified Overtime Compensation Correctly, or Be Prepared to File Corrections

One of the biggest takeaways from the new IRS guidance is that if the amount of QOC reported on the W-2 is wrong, employees are going to rely on employers to correct it using Form W-2c. Employees rely on their employers to report accurate amounts since they use the W-2 when calculating and claiming their deduction on Schedule 1-A (Form 1040).  The IRS provides guidance for the following scenarios:

• Employer Discovers an Error: If an employer discovers an error made in Form W-2, Box 12, Code TT, the employer must file a Form W-2c, Corrected Wage and Tax Statement and furnish the Form W-2c to the employee as soon as possible. An employer that files or furnishes an incorrect W2 may be subject to penalties.
• Employer Overstates the Amount: If an employer overstates the amount of QOC on the W-2, the employee cannot claim the overstated amount. The employee is only entitled to the QOC amount they actually received during the taxable year.  For example, if an employee actually received $5,000 in QOC but the employer erroneously reported $10,000 on the W-2, the employee may only include $5,000 for their deduction.
• Employer Understates the Amount: If the employee believes the employer omitted or understated the amount of QOC on the W-2, the employee must request a Form W-2c (corrected form) from their employer that properly reports the accurate amount. This is because any amount not reported on the W-2 may not be considered for purposes of the deduction.
• Employer Refuses to Correct the Understated Amount: Although employers are required to correct inaccurate W-2 information, if an employer is unwilling or unable to provide an employee with a Form W-2c with the higher corrected QOC amount, the employee is only entitled to use the lower/understated QOC amount reported on the W-2 to determine their deduction. This may lead to complaints raised by the employee or an employee association. For example, if an employer paid an employee $10,000 of QOC but only reported $5,000 on the W-2, and then refuses to furnish a corrected W-2c upon the employee’s request, the employee is only allowed to include $5,000 of QOC for their deduction.
• Employee Cannot Self-Correct the Understated Amount: If the employer is unwilling or unable to provide the employee with a Form W-2c to correct the amount, the employee cannot take matters into their own hands by using a substitute W-2 (Form 4852). The OBBBA only allows deductions based the amount of QOC received during the taxable year and reported on the W-2. Form 4852 does not satisfy that requirement since it is not a form furnished by the employer. In this type of situation, the employee only entitled to use the lower/understated QOC amount reported on the W-2 to determine their deduction.

What Should Public Agencies Do Now?

1. Audit payroll coding.Make sure the system can distinguish FLSA-required overtime from additional overtime paid under an MOU or agency policy.
2. Prepare for 2026 W-2 reporting.Payroll vendors and internal systems should be configured to separately track QOC for Code TT reporting.
3. Be prepared in case employees request corrections to the QOC amounts. Have a plan to check QOC calculations and be responsive to employee requests.

The IRS FAQs are guidance, not regulations, and the IRS expressly cautions that the FAQs may be revised and will not be relied on or used by the IRS to resolve a case. Still, they provide an important roadmap for employers as the OBBBA overtime deduction reporting gets underway.