Overtime Deduction
1. Employer Eligibility
- Who is affected?
The deduction is available to individual taxpayers (employees and certain independent contractors), not to employers themselves. However, employers play a critical role in enabling employees and contractors to claim the deduction by providing required information. - Which payments qualify?
Only “qualified overtime compensation” is eligible. This is defined as overtime pay required under section 7 of the Fair Labor Standards Act (FLSA)—that is, the “premium” portion (the “half” in “time-and-a-half”) paid for hours worked over 40 in a workweek, in excess of the employee’s regular rate. Overtime paid under state law or employer policy that is not required by the FLSA does not qualify. Overtime paid to FLSA-exempt employees is not eligible for the deduction.
2. Reporting Requirements
- New Information Reporting Obligations:
Employers must separately report the total amount of qualified overtime compensation paid to each employee for the year. This is a new requirement under IRC §225(c) and is in addition to existing wage reporting. - Form W-2 Changes:
For employees, the total amount of qualified overtime compensation must be included on the Form W-2, in a new box or field (anticipated to be Box 14 or a new Box 12 code in future years). For 2025, the IRS has announced that Forms W-2 and 1099 will not be updated to include a dedicated field for this purpose, so employers should use a reasonable method to provide this information, such as including it in Box 14 or via a supplemental statement with the W-2. - Please note if you view an annual paystub, overtime generally includes both the time and a half as one total but employers will need to find an accurate way to report just the half time to their employees in box 14 or as a supplemental statement because that is the only part eligible for the deduction.
- Form 1099-NEC for Contractors:
For independent contractors, payors must report qualified overtime compensation on Form 1099-NEC, with a separate accounting of the amount, though for 2025, this may be done via a supplemental statement. - Aggregate Reporting:
Even if the separate overtime amount is not provided, the total compensation (including overtime) must still be reported in the aggregate on the Form W-2 or 1099.
3. Transition Relief for 2025
- Penalty Relief:
For tax year 2025, the IRS will not impose penalties under IRC §§6721 and 6722 for failure to separately report the total amount of qualified overtime compensation on information returns or payee statements, provided the employer otherwise files a complete and correct return or statement. This transition relief is due to the short lead time and the fact that IRS forms will not be updated for 2025. - Encouragement to Provide Information:
While not required for penalty relief, employers are encouraged to provide employees and payees with a separate accounting of qualified overtime compensation to help them claim the deduction. This can be done via Box 14 of Form W-2, a supplemental statement, an online portal, or other secure means. - In practice, employees may not be happy if the reason they can’t take the deduction for 2025 is because their overtime is not accurately reported to them by their employer.
4. Actions Employers Should Take
A. Payroll and Reporting Systems
- Review payroll systems to ensure the ability to identify and track the “overtime premium” portion of FLSA-required overtime pay separately from regular wages.
- Prepare to update payroll and reporting systems for 2026 and beyond, when dedicated fields on Forms W-2 and 1099 are expected.
B. Employee and Contractor Communications
- Develop a communications plan to educate employees and independent contractors about the new deduction, including:
- Not all overtime is eligible (only FLSA-required overtime qualifies).
- The deduction is claimed on the individual’s federal income tax return, not through payroll withholding.
- The deduction is subject to annual limits ($12,500 for singles, $25,000 for joint filers) and phases out for higher-income taxpayers (reduced by $100 for each $1,000 of modified AGI over $150,000/$300,000).
- Inform employees and contractors how and where to find the reported overtime amount (e.g., Box 14 of Form W-2 or a supplemental statement).
C. Compliance and Documentation
- Maintain accurate records of overtime hours and payments, and ensure that overtime is classified and calculated in accordance with the FLSA.
- For independent contractors, ensure that any overtime premium paid under FLSA-equivalent arrangements is separately tracked and reported.
D. Monitor Guidance
- Stay alert for further IRS guidance on the definition of “qualified overtime compensation,” reporting procedures, and any changes to forms for 2026 and later years.
5. Additional Considerations
Temporary Provision:
The deduction is available only for tax years 2025 through 2028.
No Change to Withholding:
The deduction does not affect payroll tax withholding. Overtime pay remains subject to federal income tax withholding, Social Security, and Medicare taxes. The deduction is claimed by the employee or contractor on their individual tax return [2].
State and Local Taxes:
The new deduction applies only to federal income tax. State and local tax treatment of overtime pay is unchanged.
Disclaimer: The information provided is general in nature and not a substitute for personalized professional advice from a qualified accountant or tax advisor.
Using the website or reading its content does not create a professional relationship (e.g., attorney-client or accountant-client).
The website is not responsible for any loss, damage, or expense arising from the use of the information on the site.
The website disclaims responsibility for the completeness, accuracy, or timeliness of the information, acknowledging that tax laws and interpretations can change.
IRS Circular 230 Notice: Any U.S. federal tax advice on the site is not intended to be used for the purpose of avoiding penalties under the Internal Revenue Code, nor for promoting or recommending any transaction.
Please consult with a qualified professional tailored to their specific circumstances before acting on any information.
The website is not responsible for the content or services offered on linked third-party sites
