New IRS Guidance on Overtime Deductions and Paid Family Leave: What Employers Need to Know

The IRS has released new guidance addressing two employer provisions of the One Big Beautiful Bill Act (OBBBA): the deduction for qualified overtime compensation and the expanded employer tax credit for paid family and medical leave.

For employers, the latest guidance provides some important answers about what changes in 2026, particularly when it comes to payroll reporting.

One point is especially important: "No Tax on Overtime" does not mean overtime pay is no longer taxable. 

The provision creates an individual income tax deduction for certain qualified overtime compensation. Overtime compensation remains subject to income and payroll taxes.

Here’s what employers should know.

The IRS Has Updated Its Overtime Guidance for 2026

In August 2026, the IRS issued an updated fact sheet with additional guidance on the qualified overtime deduction, providing significantly more detail for employers.

The updated guidance addresses:

• 2026 W-2 and 1099 reporting
• Federal income tax withholding
• Determining qualified overtime compensation
• FLSA coverage and exemptions
• Correcting reporting errors
• Overtime paid under arrangements that exceed FLSA requirements
• Special situations involving compensatory time and alternative overtime calculations

Read the IRS Qualified Overtime FAQs →

The deduction is available for tax years 2025 through 2028.

What Counts as Qualified Overtime?

This continues to be one of the most important distinctions for employers and employees.

The deduction does not apply to all overtime pay an employee receives.

Qualified overtime compensation generally includes only the portion of overtime compensation that:

1. Is required under Section 7 of the Fair Labor Standards Act (FLSA), and
2. Exceeds the employee’s regular rate of pay.

For an employee receiving the standard FLSA time-and-a-half rate, that generally means the additional "half" portion of the overtime rate, not the employee’s entire overtime earnings.

For example, if an employee’s regular rate is $20 per hour and the employee receives $30 per hour for FLSA overtime, the $10 overtime premium is generally the qualified overtime compensation.

That distinction becomes particularly important in 2026 because employers are responsible for separately reporting qualified overtime amounts.

2026 W-2 Reporting: Box 12, Code TT

One of the most important pieces of the new guidance is confirmation of the 2026 reporting requirement.

Beginning with tax year 2026, employers must separately report qualified overtime compensation on an employee’s Form W-2, Box 12, using Code TT.

The amount reported is the total qualified overtime compensation paid during the year. It is not limited to the amount the employee may ultimately be able to deduct on their personal tax return.

Employers that discover an error in the amount reported under Code TT are generally required to correct the W-2 using Form W-2c.

How Much Can Employees Deduct?

The maximum deduction is:

$12,500 per individual tax return

or

$25,000 for a joint return.

The deduction begins to phase out when modified adjusted gross income exceeds $150,000 for an individual or $300,000 for joint filers.

These limits apply to the employee’s individual tax deduction. They do not change the amount of qualified overtime compensation the employer must report.

For additional information on eligibility and the individual deduction, employers and employees can visit the IRS Working Families Tax Cuts resource.

Learn More About the Overtime Deduction from the IRS →

Employers Still Withhold Taxes on Overtime

The phrase “No Tax on Overtime” can understandably create confusion for employees.

Qualified overtime compensation remains subject to federal income tax withholding and payroll taxes. Employers should not automatically reduce the wages subject to withholding because an employee may qualify for the overtime deduction.

Employees who want their withholding to reflect an expected overtime deduction may be able to account for the deduction when completing their Form W-4.

That distinction is worth communicating to employees:

The tax benefit generally occurs through an individual income tax deduction. It is not an exclusion of overtime wages from payroll taxes or an automatic elimination of federal income tax withholding.

Employers May Need to Look More Closely at How Overtime Is Calculated

For most FLSA overtime-eligible employees, qualified overtime compensation generally represents the portion of FLSA-required overtime pay above the employee’s regular rate.

But not every overtime arrangement is that simple.

Employers may pay overtime or premium pay because of:

• State law
• Collective bargaining agreements
• Company policies
• Daily overtime rules
• Weekend or holiday premiums
• Double-time arrangements

Those payments are not automatically qualified overtime compensation for purposes of the federal deduction.

If an employer pays more overtime than the FLSA requires, only the amount attributable to the applicable FLSA overtime requirement generally qualifies.

The IRS has also provided guidance for employers using certain alternative FLSA overtime provisions and other special pay arrangements.

For employers with more complex pay practices, this makes accurate payroll configuration and FLSA calculations especially important.

Paid Family and Medical Leave Tax Credit Also Gets New Guidance

Overtime isn’t the only OBBBA provision receiving additional guidance.

The Treasury Department and IRS also issued Notice 2026-28, addressing the expanded employer credit for paid family and medical leave under Internal Revenue Code Section 45S.

The OBBBA made the credit permanent and expanded the ways qualifying employers may claim it beginning in 2026.

Previously, the credit was generally based on wages employers paid to qualifying employees while they were on family and medical leave.

Beginning in 2026, qualifying employers may also be able to claim the credit based on premiums paid for qualifying paid family and medical leave insurance coverage.

That creates two potential approaches:

Wage method: Based on qualifying wages paid during eligible family and medical leave.

Premium method: Based on qualifying insurance premiums used to provide eligible paid family and medical leave benefits.

Employers may potentially use both methods for different leave benefits, but they cannot claim both methods for the same benefit.

Read the IRS Guidance on the Paid Family and Medical Leave Credit →

More Employees May Now Be Included

The OBBBA also changed the definition of a qualifying employee for purposes of the credit.

The law generally limits qualifying employees to those customarily employed for at least 20 hours per week, while allowing an employer to elect to include employees after six months of employment rather than the previous one-year period.

Employers considering the credit should review their eligibility, written leave policies and employee populations with their tax advisor.

What About State and Local Paid Leave?

The law also changes how state- or locally required paid leave interacts with the federal credit.

Leave required by state or local law, or paid for by a state or local government, may now be considered when determining whether an employer provides enough paid family and medical leave to qualify as an eligible employer.

However, that mandated or government-paid leave generally does not count when calculating the amount of the federal credit itself.

This distinction may be particularly important for employers operating in jurisdictions with their own paid family or medical leave requirements.

Employers Using Blended Insurance Policies Will Need Records

Some paid leave insurance policies may cover both qualifying and nonqualifying benefits.

When that happens, employers generally need to allocate the premium between qualifying and nonqualifying coverage using a reasonable method based on objective criteria and supported by appropriate records.

This is one area where employers considering the premium-based credit should work closely with their insurance provider and tax advisor.

More Guidance Is Still Coming

The August guidance gives employers more direction, but implementation of the OBBBA is still evolving.

Treasury and the IRS have indicated that additional regulations addressing the paid family and medical leave credit are expected.

Employers should continue watching for federal guidance as agencies implement the law.

What Employers Should Do Now

With 2026 payroll already underway, employers should make sure their systems and processes are prepared for the new requirements.

For qualified overtime, that means confirming that:

• FLSA-qualified overtime compensation can be identified separately from other premium pay
• Qualified overtime is being tracked accurately throughout the year
• Payroll is prepared to report the appropriate amount in Form W-2, Box 12, Code TT
• Employees understand that the deduction does not make overtime wages automatically tax-free
• Payroll and HR teams know where more complex overtime arrangements may require additional review

Employers that provide paid family and medical leave should also talk with their tax and benefits advisors about whether the expanded Section 45S credit could apply to their organization.

The OBBBA created significant changes for employers, but many of the practical details continue to take shape through IRS and Treasury guidance.

CTR Payroll | HR will continue monitoring these developments and updating our resources as additional guidance becomes available.

Looking for more OBBBA resources?

Visit the CTR One Big Beautiful Bill Act Resource Center for employer guidance, payroll information and the latest updates.

Disclaimer: This blog is for general informational purposes and is not legal advice.