A new temporary above-the-line deduction for overtime pay, enacted as part of the One Big Beautiful Bill Act (OBBB), is creating significant uncertainty for employers and tax practitioners. While the deduction is effective for 2025, the IRS has yet to issue crucial guidance on how to define “qualified overtime” or how employers must report it, leaving many professionals questioning how to advise clients.
Uncertainty Over ‘Qualified Overtime’ Definition
Effective for tax years 2025 through 2028, the OBBB allows individuals to deduct the premium portion of their overtime pay – the “half” in “time-and-a-half” pay – under IRC § 225. The deduction is available for overtime compensation required under Section 7 of the Fair Labor Standards Act (FLSA).
Practitioners, however, are grappling with how this federal standard applies to states with more generous overtime laws. An October 21 ABA Tax Section panel discussed California, as an example, noting it requires overtime for employees who work more than eight hours in a day, even if they do not exceed 40 hours in a week.
Deloitte’s Rachel Leiser Levy said during the ABA panel, there’s an “open question” about “places where there’s a state law that requires additional overtime in excess of the floor that the Fair Labor Standard Act provides.” Without clear guidance, it is unknown if overtime paid solely to comply with state law will be eligible for the federal deduction.
Employers, too, may choose to go farther than the FLSA and states require in terms of overtime pay. ADP’s Dan Lewis, speaking on an October 22 Council for Electronic Revenue Communication Advancement (CERCA) panel, noted that “many employers provide more generous benefits to their employees, whether it’s a rate of pay that’s higher than 1.5 times the regular rate of pay, whether it’s overtime based on working something other than 40 hours a week.” Employers also might include PTO in their 40-hour threshold or pay overtime for working holidays or weekends, Lewis added.
And some employees may also be confused about whether they qualify for the deduction. Littler’s William Hays Weissman, speaking on the ABA panel, explained that the OBBB provision doesn’t seem to cover people under the Railway Labor Act. “Maybe was an oversight that [Congress] might correct,” he added. But “to date,” it hasn’t. (More on the legislative effort here)
Employer Reporting Obligations Unclear
The new deduction places a significant reporting burden on employers, who must provide the necessary information for their employees to claim it. While this is an individual-level deduction, employers are directly impacted.
Levy said clients have asked her, “Why do I care about this? This is an individual deduction.” She explained that “nobody’s going to be able to claim these deductions without the reporting from their employer. So it’s putting an awful lot of pressure on employers.”
“Employers haven’t been tracking overtime based strictly on the FLSA standard, at least in most cases,” said Lewis. But he noted that for the 2025 period, there’s a “reasonable methods approach” for calculating and accounting for overtime. “We don’t have many details on what that looks like,” he said. What we do know is “there aren’t going to be changes to forms and changes to recordkeeping.”
Lewis added that while “ADP has always had the ability to also report on the premium portion of overtime” – that is, the portion eligible for the new deduction – he’s not certain that’s true of other systems. In addition, he said, employers don’t all “leverage that functionality, historically.”
For now, employers are wondering what they will have to provide and how the IRS will police the deduction, said Priya Schwartzburt of Vialto Partners during the ABA panel. “It’s going to be a little hard to go back and recalculate” overtime if “employers are calculating it a completely different way,” she explained.
Going forward, the IRS has indicated that employers will be required to report the total amount of qualified overtime compensation paid during the year. A draft of the 2026 Form W-2 includes a new code, “PP,” for use in Box 12. Instructions for the 2026 Form W-2 have yet to be released, said Levy.
Levy offered that, given the complexities and time-limited nature of the overtime deduction, “this isn’t where the IRS should pick a fight.” But Levy, who previously served as IRS Associate Chief Counsel, Employee Benefits, Exempt Organizations and Employment Taxes, noted she’s no longer at the IRS and “they are not asking me.”
Other Concerns
The uncertainty extends to the deduction’s effect on other tax calculations. Because the overtime deduction is taken above the line, it reduces a taxpayer’s adjusted gross income (AGI), noted the ABA panelists. PwC’s Veena Murthy elaborated that a change to a taxpayer’s AGI could affect their eligibility for other means-tested benefits.
That includes premium tax credits under the Affordable Care Act, Murthy explained. In these instances, an incorrect overtime deduction “has all kinds of sort of reverberating implications,” she added.
Weissman also noted potential state tax conformity issues. Not all states automatically adopt changes to the federal Tax Code. “You could have a situation where someone has an exclusion from federal income tax and not state income tax,” Weissman explained. That can “dilute the benefit and make this more complicated.”
For more on the new overtime deduction, see Checkpoint’s Federal Tax Coordinator 2d ¶ H-3571.
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