Is Your Payroll Company Correctly Calculating the "No Tax on Overtime" Rule? Penalties Will Apply for the 2026 Tax Year
Overview
The One Big Beautiful Bill Act (OBBBA) introduced a new federal income tax deduction for certain overtime compensation for tax years 2025 through 2028. The common shorthand "no tax on overtime," is inaccurate. The law does not exempt overtime from taxation. Instead, it allows employees to deduct a limited category of "qualified overtime compensation" on their individual returns.
As defined by the statute and, Internal Revenue Service (IRS) guidance, qualified overtime compensation is limited to overtime pay required under Section 7 of the Fair Labor Standards Act (FLSA) that exceeds the employee’s regular rate. In practical terms, this is generally the additional "half" portion of time-and-a-half pay, not the entire overtime rate.
What Qualifies—and What Does Not
The definition is narrower than many employers expect. Only overtime required under federal law qualifies. Overtime paid solely due to state law, collective bargaining agreements, or employer policy is not included. For example, daily overtime requirements under California law, industry-specific overtime rules in states like New York, or contract-based premiums will not qualify if they exceed what the FLSA itself requires. Likewise, where an employer pays double time or other enhanced premiums, only the portion necessary to satisfy the FLSA minimum overtime obligation is potentially eligible.
The Central Problem: Unbundling Overtime
The primary compliance challenge is operational, not conceptual. The deduction is tied to FLSA wage-and-hour concepts, but most employers calculate and pay overtime under multiple, overlapping frameworks at the same time. These often include weekly FLSA overtime, state-law rules such as daily overtime or seventh-day premiums, and contractually required pay under collective bargaining agreements or internal policies.
Payroll systems typically aggregate these payments under a single overtime earning code. They are not designed to distinguish between the FLSA-required overtime premium and additional compensation paid for other reasons. As a result, employers must effectively reconstruct the calculation. This requires identifying the FLSA workweek, determining the regular rate under federal law, isolating the hours that trigger FLSA overtime, and then separating only the statutory premium portion from all other premium pay.
2025 Transition vs. 2026 Enforcement
For tax year 2025, the IRS has provided limited transition relief. Employers may use a reasonable method to approximate qualified overtime compensation, and there is no penalty for failing to separately report those amounts on Forms W-2.
That relief will not continue. Beginning with the 2026 tax year, employers will be required to track and report qualified overtime compensation with greater precision. At that point, the distinction between FLSA-required premium pay and all other forms of overtime compensation becomes a reporting obligation, not just an internal calculation. An additional logistical complexity: the deduction only applies to federal income tax but does not apply to state or local income taxes, nor does it affect Federal Insurance Contributions Act (FICA)/Medicare (payroll taxes).
Risk and Potential Liability
The most significant risk arises from misclassification, particularly where employers rely on payroll vendors that do not apply FLSA concepts correctly: an employer’s use of a vendor does not relieve the employer of its employment reporting obligations or liability for employment taxes. Many systems do not calculate the FLSA regular rate or isolate the statutory overtime premium. If a system treats all overtime or all hours above a threshold as "qualified," the reported amounts will likely be inaccurate.
Beginning in 2026, inaccurate reporting may lead to information return penalties and increased audit scrutiny. There is also a secondary risk if employers communicate or imply that certain overtime is "eligible" or "tax free" without qualification. Although the deduction is ultimately determined by the employee, employers are the source of the underlying compensation data and may face exposure where inaccurate classifications are communicated and relied upon. While there may be penalty reductions for timely corrections or de minimis errors, generally, an employer who furnishes a W-2 with incorrect information could be subject up to a fine of hundreds of dollars per incorrect statement, with a maximum penalty of millions per calendar year, adjusted annually for inflation; moreover, penalties increase without limit for “intentional disregard” and may even be referred for criminal punishment for “willfully” furnishing a false or fraudulent W-2.
Takeaway
This is not simply a tax issue. It is a wage-and-hour classification problem embedded in payroll operations. Employers should use the 2025 transition period to confirm that their payroll systems, or their payroll vendors, can separate FLSA overtime premiums from other forms of overtime compensation and that any methodology used is consistent, documented, and defensible before reporting requirements take effect in 2026.
Please feel free to contact the authors of this Client Alert or your Butzel attorney for more information.
Nicholas Nahat
248.258.2520
nahat@butzel.com
Brett J. Miller
313.225.5316
millerbr@butzel.com
