Public employers face a near‑term compliance puzzle as the One Big Beautiful Bill Act (OBBBA) creates a temporary federal tax deduction for “qualified overtime compensation” while imposing new reporting expectations. The deduction, effective retrospectively from 1 January 2025 through 31 December 2028 unless extended, permits employees to deduct the overtime premium that FLSA requires (for example, the “half” of time‑and‑a‑half pay); annual caps are $12,500 for single filers and $25,000 for joint filers, with phase‑outs beginning at $150,000 and $300,000 of modified adjusted gross income respectively. According to IRS guidance, employers will ultimately be required to report qualified overtime on Forms W‑2 and 1099, but the agency has provided transition relief for tax year 2025.

At the heart of employer decision‑making is a clear statutory distinction: the deduction applies only to overtime that is “required under Section 7 of the Fair Labor Standards Act” , essentially weekly overtime (or overtime calculated under a lawful alternative workweek such as section 7(k) for public safety personnel). Industry and legal commentary emphasise that only FLSA‑required overtime qualifies; state, contractual or employer‑generous overtime arrangements that go beyond Section 7 do not, by themselves, create deductible overtime. Employers therefore must be able to separate FLSA‑mandated overtime from other overtime or premium payments when preparing employee statements.

Common forms of premium pay that fall outside the OBBBA deduction unless they are themselves FLSA weekly overtime include state daily overtime and double‑time rules, contractual or MOU (collective bargaining) overtime provisions, discretionary or non‑regular pay elements excluded from the FLSA “regular rate,” and employer choices to pay exempt staff additional compensation. Payroll practices that count paid time off toward overtime thresholds or include non‑regular pay in the regular rate can produce pay that is generous but not eligible for the federal deduction. Employers should therefore inventory where their pay practices mirror, exceed, or diverge from Section 7 requirements.

The IRS has recognised the practical difficulty of immediate, system‑wide changes and issued transitional guidance for TY2025: Notice 2025‑69 instructs individual taxpayers on claiming the deduction without requiring employers to separately account for qualified overtime or tips on 2025 forms, and a related IRS notice confirmed that employers will not be penalised for failing to update payroll systems or W‑2s for TY2025. Nevertheless, the IRS has urged employers to prepare for mandatory reporting in later years and has published draft W‑2 changes (including a proposed code “TT” on a revised Box 12) for TY2026; employers should watch for finalised instructions.

Practical next steps for public employers include: conduct a policy and contract review to identify where overtime rules derive from FLSA, MOUs, state law or employer policy; audit payroll data and coding so weekly FLSA overtime is tracked separately from daily, double‑time, contractual or premium payments; modify payroll systems where feasible to retain discrete overtime categories; and prepare employee communications or Box 14 entries or supplemental statements if choosing to provide TY2025 assistance. Employers should also train HR and payroll staff on the OBBBA rules and document chosen “reasonable methods” for approximations where precise historical data are unavailable, consistent with the statute’s transition rule. Payroll vendors and state comptrollers have circulated similar implementation guidance and templates to help agencies assess system change costs.

The balance for public employers is between cost and employee benefit. Acting now to disaggregate and document FLSA‑required overtime can ease the shift to mandatory reporting in 2026 and support employees’ access to the deduction, but hasty or poorly documented changes risk overstated W‑2 reporting and subsequent IRS scrutiny. Industry and bar analyses urge measured, documented action: prepare systems, train staff, and adopt conservative, auditable methods for any 2025 reporting an employer elects to provide. Government guidance and draft forms remain the primary touchstones as agencies plan their next steps.

Source: Noah Wire Services

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