IRS Updates FAQs on Qualified Overtime Deduction

The Internal Revenue Service (IRS) recently updated its frequently asked questions regarding the deduction for qualified overtime compensation. The updated guidance provides additional clarification on eligibility, reporting, withholding, and the calculation of qualified overtime. It supersedes the FAQs issued in January 2026.

The qualified overtime deduction was created by the One Big Beautiful Bill Act (OBBBA), P.L. 119-21, and applies to tax years 2025 through 2028. Although commonly referred to as the “no tax on overtime” deduction, overtime pay is not completely tax-free. Instead, eligible taxpayers may claim a federal income tax deduction for certain qualified overtime compensation.

What Is Qualified Overtime?

Qualified overtime compensation refers to the portion of overtime pay required under section 7 of the Fair Labor Standards Act (FLSA).

For example, if an employee earns $20 per hour and receives $30 per hour as a result of FLSA-required overtime, the $10 premium above the regular $20 rate may qualify for the deduction.

Not all overtime payments qualify. Overtime paid solely under an employer policy, employment agreement, collective bargaining agreement, or state law does not automatically qualify. The overtime must be required under section 7 of the FLSA.

How Much Can Be Deducted?

The deduction is limited to:

• $12,500 for individual taxpayers; and
• $25,000 for married taxpayers filing jointly.

The deduction begins to phase out when modified adjusted gross income exceeds $300,000 for married taxpayers filing jointly or $150,000 for other taxpayers.

The deduction is available whether the taxpayer itemizes deductions or claims the standard deduction.

It is also important to distinguish between the amount of qualified overtime reported by an employer and the amount ultimately deducted by the employee. The employee's deduction remains subject to the applicable limits and income phaseout.

New Employer Reporting Requirements

One of the most important items in the updated IRS guidance applies to the employer reporting requirements beginning in 2026.

Employers must separately report qualified overtime compensation on Form W-2, Box 12, using Code TT. Employers therefore need payroll systems and procedures capable of identifying and tracking qualified overtime separately from other wages and overtime payments. The reporting relief provided for 2025 is not available for 2026.

The amount reported by the employer may be greater than the amount the employee can ultimately deduct because the employee must apply the statutory deduction limits and income phaseout when filing the tax return.

The new FAQs indicate that, in the IRS’s view, qualified overtime compensation would be reported on forms other than Form W-2 (e.g. Form 1099-MISC or Form 1099-NEC) only in rare circumstances. Such a situation could occur where a worker is classified as an employee for FLSA purposes but as an independent contractor for purposes of the Internal Revenue Code.

What If the W-2 Is Incorrect?

The IRS also provided additional guidance for correcting errors in qualified overtime reporting.

If an employer reports an incorrect amount of qualified overtime compensation on Form W-2, the employer should generally issue a Form W-2c, Corrected Wage and Tax Statement.

Employees should not simply substitute their own calculation for the amount reported by their employer. The IRS has clarified that Form 4852 cannot be used to claim qualified overtime compensation that was not properly reported on Form W-2.

Employers should therefore establish procedures for reviewing and correcting qualified overtime reporting errors.

Who May Qualify?

Eligibility generally depends on whether the employee is covered by the FLSA and entitled to overtime under the FLSA.

Certain employees are exempt from FLSA overtime requirements, including some executive, administrative, professional, outside sales, computer-related, agricultural, and other employees who meet the applicable exemption requirements.

The updated FAQs also address employee-owners. An employee-owner who owns at least a bona fide 20% equity interest in a business and is actively engaged in managing the business generally is treated as exempt from FLSA overtime requirements and therefore generally would not qualify for the deduction.

Employers must carefully evaluate an employee's actual duties and applicable FLSA requirements rather than relying solely on job titles.

What About Payroll Withholding?

The qualified overtime deduction does not mean employers should stop withholding federal income tax from overtime wages.

Overtime compensation (qualified or otherwise) generally remains subject to federal income tax withholding and applicable employment taxes. However, employees who expect to claim the deduction may submit an updated Form W-4 to account for the anticipated deduction.

The deduction is ultimately claimed by the employee on the federal income tax return.

What Should Employers Do?

Employers should review their payroll and reporting procedures before preparing 2026 Forms W-2. Employers should:

• Review employee FLSA classifications and related overtime requirements.
• Confirm how payroll systems identify qualified overtime compensation.
• Track qualified overtime compensation separately.
• Ensure qualified overtime compensation is properly reported using Form W-2, Box 12, Code TT.
• Establish procedures for correcting reporting errors.
• Communicate with employees about the difference between overtime withholding and the overtime deduction.

Key Takeaway

The IRS's recent FAQ update provides important guidance as employers and taxpayers prepare for the new qualified overtime deduction and the first year of mandatory separate reporting.

For employers, accurate FLSA classification, payroll tracking, and W-2 reporting will be critical. For employees, reviewing Form W-2 and understanding the difference between qualified overtime compensation and the amount ultimately deductible will be important when preparing the 2026 tax return.

The deduction is not a blanket exemption for all overtime pay. Taxpayers must receive overtime pay that qualifies under the applicable FLSA rules and remain subject to the applicable deduction limits and income phaseout.

Sources: Internal Revenue Service, IR-2026-88, IRS Updates FAQs on Qualified Overtime Deduction, August 6, 2026; IRS, Fact Sheet FS-2026-13; Journal of Accountancy, IRS updates overtime deduction FAQs, adds reporting details, August 2026.

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