Section 70202 of Public Law 119-21, the One Big Beautiful Bill (OBBB), provides taxpayers with up to a $12,500 deduction ($25,000 if married filing jointly) against overtime pay. The new legislation does not reduce taxes for employers – instead, it gives them more reporting and compliance requirements and may increase their audit risk.
The IRS is offering transitory penalty relief for tax year 2025, but employers should still understand the rules, prepare to implement the changes, and be aware of the audit risks. If you’re facing a payroll audit, you need an experienced legal team – contact us at Wiggam Law today.
Key takeaways
- The OBBB offers individual taxpayers up to a $12,500 above-the-line deduction against overtime pay.
- Unless extended, the deduction is only available for tax years 2025 to 2028.
- Employers must report overtime pay to the employee, the IRS, and the Social Security Administration.
- The IRS has not issued final guidance on where to report overtime payments on 2025 W-2 forms.
- Employers should ensure payroll software is up to date so they can calculate income tax withholding correctly for tax years 2026 through 2028.
- Track payments and keep detailed records to protect your business in case of an audit.
What Does No Tax on Overtime Mean?
Colloquially, this provision is called “no tax on overtime,” but it’s actually a tax deduction that individual taxpayers can claim against the overtime portion of their overtime (also called the premium portion). For example, if they get paid time and a half, the deduction counts against the half-time of extra pay.
Individuals may claim up to a $12,500 deduction, while married couples filing jointly may claim up to a $25,000 deduction, regardless of which spouse earned the overtime. If you’re married, you cannot claim this deduction if you file separately. But to claim the deduction, individuals need the right records – and that comes from their employers.
How should employers report overtime pay?
Prior to the OBBB, employers were required to pay overtime to non-exempt employees who worked over a certain number of hours, but they didn’t have to note the overtime payments on employees’ tax forms. The OBBB changed that – now, employers must report overtime payments on employee wage forms, but unfortunately, the W-2 forms for tax year 2025 have already been created without a separate box for overtime pay.
For tax year 2025, employers may furnish a separate statement to their employees and the government, showing the amount of overtime paid to each employee. Alternatively, employers may note overtime payments in Box 14 of the W-2. To be on the safe side, check to see if the IRS issues any additional guidance before the February 2, 2026, deadline for issuing W-2 forms or consult with an experienced tax preparer.
The W-2 form is set to be updated for tax year 2026, and it’s likely to use Box 12 for overtime pay. When filing 2025 tax returns, individuals may use their final pay stubs (which do break out overtime in most cases) to prepare their tax returns. At the time of writing, it’s unclear whether the IRS will accept pay stubs as the employer’s statement about overtime.
Potential Areas for Employer Confusion
The verbiage “no tax on overtime” is slightly misleading – as explained above, individuals may claim an income tax deduction against their overtime pay, but the payments are still subject to FICA taxes and must be reported as income. For individuals filing an income tax return, the deduction will be fairly easy to claim as long as they have the right numbers.
However, the new rule creates a risk of confusion for employers. Here are some of the areas where employer confusion may lead to reporting errors or other issues.
- Confusion about how “no tax on overtime” works – overtime pay is still subject to FICA taxes. You must include overtime payments when filing payroll tax returns, withhold FICA taxes as usual, and send in the employer matching payments. Overtime pay also counts toward the federal unemployment payments.
- Variances with state income tax laws – some states are set up to follow certain aspects of the federal tax code, meaning they’ll also exempt these payments from state income tax. Other states may tax these payments. If you have employees in a state with income tax, it’s critical that you remember to report these payments as income on state withholding and unemployment returns.
- Reporting requirements – final guidance has yet to be published, but based on how the deduction works, employers will likely be required to report the amount of extra pay that was paid to the employee, not the full amount of overtime pay. For example, if your employee earned $12,000 in overtime pay at the time-and-a-half rate, $ 4,000 of that is considered overtime pay. If they earned $12,000 at a double-time overtime rate, $ 6,000 is considered overtime pay. In either case, noting the full $12,000 as overtime pay will lead to inflated deductions and potentially increased audit risks for employers.
- Claims for S-corp shareholders – S-corp shareholders are exempt employees under the FLSA, meaning they’re not subject to overtime rules. Thus, they’re not eligible to claim this deduction and should not have overtime reported on the W-2 they receive from the S-corp.
- Penalties for not filing information returns – the IRS applies steep penalties to unfiled information returns. Even if an employer files their W-2 and W-3 forms correctly and on time, they may be exposed to penalties for not providing statements detailing overtime pay. Again, the IRS has offered transitory penalty relief, but that doesn’t always apply correctly, uniformly, or timely – so if you incur a penalty, contact the IRS or a tax attorney.
- Greater scrutiny around exempt employees – under the Department of Labor’s (DOL) rules, some employees are exempt from overtime. The rules are very clear about which types of roles and which pay rates are exempt from overtime, but there’s always room for confusion. If you have an employee who you’ve internally classified as exempt, they may look deeper at their role to see if they qualify for overtime pay and the new tax deduction. If they reach out to the IRS or the DOL for clarity on their exempt status, that can put you at risk. To protect your business, review exempt employees and ensure they truly qualify as exempt.
As an employer, you need to ensure that you understand the rules. You should also be prepared to address employee concerns about how the new rules work.
Key Employer Responsibilities Under the New Overtime Rules
How do you stay compliant with the new overtime reporting rules as an employer? Consider the following.
Payroll software compliance
Payroll software providers are actively updating their software to ensure compatibility with the OBBB’s new rules. For tax year 2025, ensure that you’re able to see overtime hours paid so that you can furnish the employee and the government with a statement.
For tax years 2026 to 2028, verify that the software will track overtime payments, but also make sure that it considers the OT deduction when calculating income tax withholding for paychecks that involve overtime pay.
Implementing the rules
You must track overtime separately from any other rates of pay. For example, if you pay employees time and a half for holidays, you should ensure that it’s tracked separately from overtime pay. Also, make sure that bonuses or any other additional compensation are not reported as overtime pay.
Documentation and recordkeeping
In case you are selected for an audit, you should keep employee time cards that clearly show which hours were overtime and which were regular, holiday, or other rates. The IRS may look for collusion – for example, an employer classifying regular pay as overtime pay to increase the deduction for employees who are friends or family members.
You may want to conduct internal audits to ensure that your payroll software or vendor is accurately tracking and reporting the correct information.
Employee Communication
There’s likely to be a lot of employee confusion about the new overtime rules. Employers generally should not give employees legal or tax advice, but at the same time, you need to be ready to answer some of their questions.
- What “no tax on overtime” means – let employees know that the overtime pay is still subject to FICA taxes and that the base rate is also subject to income tax. It’s just the extra pay that’s eligible for the deduction.
- Claiming the deduction for 2025 – let employees know that they may want to keep their final paystub of the year, so they can claim the deduction against overtime pay, or provide them with a statement showing overtime pay when you give them their W-2 forms.
- Potential for greater tax refunds in tax year 2025 – the new rules do not have any impact on take-home pay for tax year 2025. But some employees may get an increased tax refund when they claim the deduction on their tax returns.
- How it affects take-home pay – for tax years 2026 through 2028, payroll software should consider the exemption when calculating take-home pay, and thus, employees shouldn’t see taxes eroding their take-home pay when they earn overtime, as they often experienced in previous years.
- Limitations – the deduction is worth up to $25,000 for married couples filing jointly, even if only one spouse earned the overtime pay. However, payroll software is likely to only take into account the individual $12,500 deduction. So, married employees may have extra income tax withheld from their pay if they go over the $12,500 threshold, but they should be able to claim a refund of those withheld taxes based on the rest of their tax situation.
Payroll Audits and No Tax on Overtime
Major tax code changes almost always lead to more audits – the IRS uses audits to spot check compliance. The agency also audits returns that have red flags indicating mistakes, such as:
- Discrepancies between W-2s and payroll tax returns.
- Unusually high overtime pay is reported in industries that generally don’t have a lot of overtime.
- Failure to report overtime on employee paystubs or W-2 forms.
Overtime and employee misclassification were already key audit areas for the IRS, and the OBBB’s new rules may increase audit rates.
How to Protect Yourself With the New Overtime Rules
Most payroll systems will incorporate the new rules – but employers are still responsible for accurate reports and returns. To protect yourself, make sure that your software updates correctly. Do internal audits to ensure compliance. Also, consult with an experienced tax professional to ensure you’re implementing the new rules correctly.
A bit of extra time can help protect you from penalties or other issues down the road.
FAQs
How can I confirm my payroll software applies the overtime exemption correctly?
If you want to test the software, consider running a few dummy payrolls so that you can see how much income tax is withheld. First, run a check for $2000 in weekly salary. Then, run a payment with $1500 in regular hourly pay and $500 in overtime pay. As long as the payments are scheduled over the same pay period and applied to employees with the same withholding requirements (for example, single or married filing jointly), the payment with the overtime pay should have less income tax taken out. If that’s not the case, contact your software provider for guidance.
What records should I keep to prove compliance with §70202?
Keep employee time cards that show regular and overtime hours. Keep proof of payments made, information used to file payroll tax returns, and employee contracts or work descriptions that establish exempt status.
Will the IRS issue specific audit guidance for overtime reporting?
Yes, the IRS will likely release more information on overtime reporting requirements before tax year 2026. Work with a reputable payroll company or consult with a tax attorney if you have concerns.
Are third-party payroll providers liable if they make an error?
Third-party payroll providers can be held liable for the Trust Fund Recovery Penalty (TFRP) if payroll taxes are not paid willfully. If you incur penalties due to their actions, you may be able to use reasonable cause to eliminate the penalty. But ultimately, you’re responsible for the information on your tax returns, including payroll returns.
How should I handle overtime earned in late 2024 but paid in 2025?
These overtime payments were paid in 2025, meaning they’re eligible for the 2025 overtime tax deduction. You should ensure this overtime pay is clearly reported to employees on a statement attached to their 2025 W-2 form.
Get Help With OBBB Compliance
The OBBB had many provisions that affect employers, and if you pay freelancers, you may even have to adjust their 1099 reports under the OBBB. The 1000+ page law also includes updates to gambling loss limitations, Opportunity Zone (OZ) investments, and capital gains exclusions for Qualified Small Business Stock (QSBS).
At Wiggam Law, we have been helping clients with tax resolution cases for over 10 years – we’re always up to date on the legal code and ready to pivot whenever changes affect our clients. If you’re facing a payroll audit or dealing with any other business tax problems, contact us for assistance today.
