The Sophisticated Employer Blog

New guidance issued by the Internal Revenue Service (IRS) provides employers with concrete steps they can take to comply with the new “no tax on overtime” rules that were codified by the federal government in the One Big Beautiful Bill Act (OBBBA) of 2025.

The IRS guidelines give employees the information they need to claim the overtime deduction on their individual returns.

The OBBBA included many comprehensive reforms to the IRS tax code that impacted corporate tax rates, base-broadening rules and international taxation. The OBBBA also included a provision to address tax on overtime in fulfillment of a promise to eliminate tax on overtime made during President Donald Trump during his 2024 presidential campaign.

While the “no tax on overtime” provisions in the bill were seen as welcome tax relief by many taxpayers, the way employers were to incorporate the tracking and reporting requirements necessary to allow employees to claim the deduction were much less clear. 

Based on the new IRS guidance, employers can now take action to comply with the new “no tax on overtime” rules and to give employees the information they need to claim the overtime deduction on their individual returns.

Overview of Overtime Deduction

The OBBBA created a temporary federal income tax deduction for “qualified overtime compensation” beginning in 2025 without changing how overtime is subject to wage withholding and FICA. Employees should continue to include overtime in taxable wages from their Form W‑2 as they did in 2024, but they can also claim a separate deduction for qualifying overtime amounts on their 2025 income tax returns, subject to statutory caps and thresholds.

“Qualified overtime compensation” generally aligns with the overtime premium required under the Fair Labor Standards Act (FLSA), which is defined as the additional one‑half of the regular rate paid for hours worked over 40 in a workweek rather than the entire overtime rate. The additional one-half of the regular rate is known in the Act as the “overtime premium.”

Employers must be able to distinguish the overtime premium component from straight‑time wages within their payroll systems when providing information on the overtime premium to their employees.

2025: Transition Year & Penalty Relief

The IRS acknowledged that employers and payroll providers need time to reconfigure their payroll systems and has characterized 2025 as a transition year for overtime information reporting. The IRS announced penalty relief for certain failures related to reporting qualified overtime and tip amounts for 2025 so employers will not automatically be penalized solely because they do not yet provide a perfectly compliant overtime figure on Form W‑2.

Despite this relief, federal guidance strongly encourages employers to begin tracking and summarizing qualified overtime for 2025 and to provide employees with a reasonable annual total for inclusion in their income tax return. By adopting overtime tracking policies and procedures early, employers can reduce compliance risk as enforcement ramps up and employees begin claiming the deduction on their 2025 returns.

Core Employer Obligations Going Forward

Although the overtime deduction is claimed on the employee’s Form 1040, the employer’s reporting obligations are central to making the deduction work in practice. Employers should focus on three reporting objectives related to overtime: (1) updating the payroll system configuration to track the overtime premium, (2) implement year‑end wage reporting to include the overtime premium, and (3) increase employee communication related to the new overtime deduction.

1. Payroll System Configuration

From a compliance perspective, employers should verify that their payroll system is accurate and provides contemporaneous overtime tracking at the payroll level. Employers should:

• Identify covered employees

• Confirm which employees are non‑exempt and subject to Fair Labor Standards Act (FLSA) overtime rules, because only FLSA‑type overtime premiums are intended to qualify.
• Pay particular attention to industries with special overtime rules (public safety, healthcare, government and similar sectors) where “overtime” may be defined by statute or collective bargaining agreement.

• Separate overtime components in payroll

• Configure payroll codes to distinguish:

• Regular hours and regular‑rate wages
• Overtime hours
• The overtime premium portion (the additional one‑half of the regular rate)

• Ensure that these codes are properly accumulated throughout the year so that total qualified overtime compensation can be produced at year‑end without manual reconstruction.

• Maintain supporting records

• Retain time sheets, schedules, FLSA classifications and pay‑code descriptions that substantiate how qualified overtime amounts are calculated.
• Document the employer’s “reasonable method” for allocating and computing qualified overtime (for example, handling blended rates, shift differentials and bonuses).

2. Year‑end W‑2 Reporting

Overtime wages remain fully included in Box 1 (wages, tips, other compensation), Box 3 (Social Security wages) and Box 5 (Medicare wages) on Form W‑2 with no exclusion for qualified overtime. The new rules overlay an additional information‑reporting concept: employers must furnish enough information for employees to identify the annual amount of qualified overtime compensation.

Key points for employers:

• Reporting overtime on 2025 W‑2 Forms

• The IRS has not updated the current W-2 to include a dedicated overtime box and the penalty relief guidance confirms that employers will not be penalized solely for failing to separately identify qualified overtime for 2025.
• That said, employers may voluntarily use Box 14 (“Other”) to report a single annual “Qualified overtime” figure for each employee. While not mandatory, this use of Box 14 to report overtime premiums is currently viewed as best practice.

• 2026 and Later Forms W‑2
• Draft guidance published by the IRS for future tax years suggests the addition of a specific W‑2 code (for example, a new Box 12 code) that would be used to report qualified overtime compensation.
• Once final instructions are issued by the IRS, employers will be expected to:

• Map the accumulated qualified overtime amount in payroll to the designated W‑2 field and code
• Ensure that the total reported aligns with internal payroll records and year‑end overtime reports

• Information‑return penalties

• • After the transition period, the failure to correctly furnish required overtime information on Form W‑2 will likely be subject to the ordinary information‑return penalty regime (for example, penalties per incorrect or incomplete W‑2, subject to annual caps).

• • Investing in payroll‑system changes and testing now will reduce the risk of systemic errors across a large employee population once full enforcement begins.

3. Employee‑facing Communications

Even a perfectly coded W‑2 can generate confusion if employees do not understand what the new overtime premium figure represents or how it interacts with their annual return preparation. Employers can mitigate this risk and reduce calls to HR and payroll by proactively explaining the new overtime line item.

Employers should consider implementing the following communication practices with employees:

• Annual overtime statement

• In addition to the W‑2 provided to each employee, an employer should also provide employees with a simple annual statement (paper or electronic) that includes:

• Total qualified overtime compensation for the year
• A brief description, such as: “This amount represents the overtime premium portion of your wages that may be eligible for a federal income tax deduction under current law.”
• Clarify that this figure does not reduce W‑2 wages and does not change Social Security or Medicare tax.
• Plain‑language FAQs
• Provide a short Q&A for employees explaining:
• That the deduction is claimed on the employee’s federal income tax return, not through payroll.
• That the amount on the annual statement or in Box 12/Box 14 of the W-2 is the number the employee (or their preparer) may use when computing the deduction, subject to IRS limits.
• That employees should consult their own tax advisor to determine eligibility, particularly if they have multiple jobs or complex income situations.
• Coordination with advisors and vendors
• Employers with unionized workforces or industry‑specific overtime rules may wish to coordinate with outside counsel to confirm which overtime categories qualify under the statute and guidance.
• HR and payroll teams should work closely with payroll providers and software vendors to ensure that W‑2 templates, year‑end reports and employee portals clearly label the overtime amount and avoid duplicative or inconsistent terminology.

Practical Checklist for Employers

To bring these objectives together, employers can use a concise compliance checklist for the overtime deduction reporting requirement:

• Legal and policy review

• Confirm how the FLSA applies to the workforce and identify which overtime premiums are intended to qualify under OBBBA guidance.
• Update written policies and employee handbooks to ensure that overtime practices align with both wage‑and‑hour and tax reporting requirements.

• Systems and data

• Implement or refine payroll codes to separately track the overtime premium portion and to accumulate an annual qualified overtime total.
• Test year‑end reports to verify that the qualified overtime total reconciles to internal records and can be mapped to the W‑2 fields or to a supplemental statement.

• Forms and communications

• For 2025, consider voluntarily reporting qualified overtime in Box 14 or on a separate statement to support employees’ deductions, even though specific reporting is not yet mandatory.
• For 2026 and later, implement whatever W‑2 coding scheme the IRS finalizes and update employee communications to explain the new field in clear, non‑technical language.

By focusing now on payroll data integrity, W‑2 reporting mechanics and clear employee communications, employers can position themselves to comply with the overtime reporting requirements while helping their employees fully utilize the new deduction.