Major federal legislation is set to change how overtime pay is taxed, and businesses need to prepare. Enacted in July 2025, the “One Big Beautiful Bill” (OBBBA) introduces significant updates that will affect payroll, employee compensation, and tax compliance for years to come. For small business owners, understanding these changes is crucial for smooth operations and staying ahead of new requirements.
This guide will walk you through the key provisions of the OBBBA, including the “No Tax on Overtime” rule and new reporting standards starting in 2026. We will explain who is eligible, what it means for your business, and how you can prepare for these new regulations to ensure seamless compliance.
Understanding the “No Tax on Overtime” Provision
A central piece of the OBBBA is the “No Tax on Overtime” provision. This rule became law on July 4, 2025, and retroactively applies from January 1, 2025, through 2028. It’s important to understand that this does not make all overtime pay completely tax-free.
Here’s what the provision does:
- It allows eligible workers to deduct a portion of their overtime earnings from their federal income tax.
- The maximum deduction is $12,500 for individual filers and $25,000 for joint filers.
- The provision only applies to federal income tax. Federal payroll taxes, which fund Social Security and Medicare, still apply to all overtime compensation.
This change was designed to reward employees who work extra hours and boost productivity. By making overtime more financially attractive, the legislation aims to support both workers and the businesses that depend on them.
Who Is Eligible for the Overtime Tax Exemption?
Eligibility for this new tax deduction depends on several factors, including employment classification and income.
Hourly Employees
Most hourly workers who are classified as non-exempt under the Fair Labor Standards Act (FLSA) are the primary beneficiaries. To qualify, they must:
- Work more than 40 hours in a week.
- Receive overtime pay at a rate of at least time-and-a-half.
- Have a valid Social Security number.
Salaried Employees
Some salaried employees may also qualify, but the rules are more specific. A salaried employee must:
- Be classified as non-exempt under the FLSA. Many salaried positions are exempt, making them ineligible.
- Earn overtime compensation that meets federal guidelines.
- Have an annual income below the specified threshold.
Income Thresholds
The deduction has an income cap. It begins to phase out for individuals earning $150,000 or more per year. This means higher-income earners will receive a reduced deduction or none at all. As an employer, you are not responsible for determining an employee’s eligibility based on their total household income; this is up to the individual taxpayer when they file their taxes.
Key Changes Coming in 2026
While the tax deduction itself began in 2025, new reporting requirements for employers will take effect starting with the 2026 tax year. The IRS has released draft versions of the 2026 Form W-2, which include new boxes to report this information.
New Reporting on Form W-2
The draft 2026 Form W-2 includes new codes for Box 12 to separately report different types of compensation:
- Code TT: For reporting total qualified overtime compensation.
- Code TP: For reporting total qualified tips.
- Code TA: For employer contributions to a “Trump account.”
Additionally, Box 14 will be updated to include Treasury occupation codes for tipped employees. These changes are designed to help the IRS and employees track income eligible for the new deductions. The Form W-2 for the 2025 tax year will remain unchanged.
How Can Employers Prepare for These Changes?
These new rules require businesses to adapt their payroll and record-keeping practices. Proactive preparation can help you avoid compliance headaches down the road.
Update Your Payroll System
One of the most important steps is recognizing that changes will be made to how your business reports overtime hours in your payroll provider’s system. The “No Tax on Overtime” deduction only applies to overtime mandated by the FLSA (typically, hours worked beyond 40 in a week). It does not apply to other types of premium pay, such as double-time or overtime paid for working on holidays, unless it is part of the FLSA-required calculation.
You may start to see updates in your provider’s system as settings are adjusted to meet the new reporting requirements. Watch for notifications from your payroll provider regarding when their system will be ready and for guidance on how to report the necessary information accurately.
Maintain Detailed Records
Accurate record-keeping is essential. Employers must keep precise records of all FLSA-mandated overtime paid to every employee. Since you won’t know which employees will ultimately qualify for the deduction based on their total income, you must track this for everyone.
Educate Your Employees
While you are not responsible for providing tax advice, you can help your employees by informing them about the changes. Let them know that they may be eligible for a new tax deduction on their overtime earnings and that you will be providing the necessary information on their W-2 forms starting in 2026. Encourage them to consult with a tax professional to understand how the deduction affects their personal financial situation.
Strategies for Ensuring Compliance
Staying compliant with evolving regulations is a top priority for any business. Here are some best practices to follow:
- Stay Informed: Monitor updates from the IRS and the Department of Labor. Guidance on these new provisions may evolve, and staying current is key.
- Consult with Integra: Work with us to ensure your systems and processes are correctly configured. We can offer guidance tailored to your specific business needs.
- Review Employee Classifications: Double-check that your employees are correctly classified as exempt or non-exempt under the FLSA. Misclassification can lead to significant penalties, especially with these new rules in place.
- Train Your HR team: Make sure your team understands the new requirements for tracking and reporting overtime pay.
Look Ahead to a Smoother Transition
The overtime and tax changes introduced by the OBBBA represent a significant shift in how employee compensation is handled. By taking proactive steps now, small business owners can prepare for a smooth transition. Updating your payroll systems, maintaining meticulous records, and staying informed will position your business for success and ensure you remain compliant.