IRS Updates Overtime Deduction FAQs and W-2 Reporting Rules

On August 6, 2026, the Internal Revenue Service (IRS) updated its FAQs on the qualified overtime compensation deduction created by the One Big Beautiful Bill Act (OBBBA). The updated guidance provides additional information on eligibility, reporting, withholding, and compliance requirements.

The most significant change for employers is that, beginning with tax year 2026, qualified overtime compensation must be separately reported on Form W-2, Box 12, Code TT. The IRS also clarified that employees may claim a deduction only for the amount reported by their employer and may need a corrected Form W-2 (Form W-2c) if errors occur.

This guidance applies to employers that pay FLSA-covered overtime compensation and takes effect for tax year 2026 reporting. The deduction itself remains available for tax years 2025 through 2028.

What Employers Should Do

Legal Requirements

• Review and comply with IRS reporting requirements for qualified overtime compensation, including Form W-2, Form W-2c, and applicable Form 1099 reporting obligations, as well as required withholding and payroll tax procedures.

Practical Considerations

• Review payroll processes and systems to ensure qualified overtime compensation can be accurately identified, tracked, calculated, and reported.
• Coordinate with payroll vendors, Human Resources Informacion System providers, and tax advisors to prepare for IRS reporting requirements.
• Consider engaging a Professional Employer Organization (PEO) or Administrative Services Organization (ASO) to assist with payroll system updates, reporting compliance, and W-2 administration related to the new requirements.

Overview

New Form W-2 Reporting Requirements: Beginning with tax year 2026, employers must separately report qualified overtime compensation in Form W-2, Box 12, using Code TT. The IRS tied the employee deduction directly to the amount reported by the employer, making accurate reporting critical.

Employees Limited to Reported Amounts: The updated FAQs clarify that employees cannot claim a qualified overtime deduction greater than the amount reported on their Form W-2. If an employer understates the amount, the employee must obtain a corrected Form W-2 (Form W-2c) before claiming a larger deduction. The IRS also clarified that employees cannot use Form 4852 (Substitute for Form W-2) to claim additional overtime deduction amounts that were not reported by the employer.

Overtime Compensation Remains Taxable: The deduction does not make overtime compensation tax-free. Qualified overtime compensation remains included in gross income and subject to federal income tax withholding, Social Security tax, Medicare tax, and Federal Unemployment Tax Act (FUTA) taxes. Eligible employees claim the deduction on their individual tax returns rather than receiving an exclusion from wages or payroll taxes.

Deductible Overtime Is Limited to the Premium Portion: The IRS clarified that the deduction applies only to overtime compensation required under the Fair Labor Standards Act (FLSA) and is limited to the overtime premium portion of the payment. For example, if an employee’s regular rate is $20 per hour and their overtime rate is $30 per hour, only the additional $10 premium qualifies for the deduction.

Expanded FLSA Guidance: The IRS expanded its guidance on FLSA coverage, overtime exemptions, federal employee eligibility, and the criteria for determining whether overtime compensation qualifies for the deduction. These clarifications help employees and employers assess whether overtime payments are eligible for the deduction.

Deduction Limits and Income Phaseouts: Eligible taxpayers may deduct up to $12,500 ($25,000 for married taxpayers filing jointly) in qualified overtime compensation, subject to a phaseout for taxpayers with modified adjusted gross income (MAGI) exceeding $150,000 ($300,000 for joint filers). The deduction currently applies to tax years 2025 through 2028.

Why This Matters

For employers, the August 2026 IRS update shifts much of the compliance focus from deduction eligibility to payroll reporting and administration. The guidance makes clear that accurate tracking and separate reporting of qualified overtime compensation will be essential for employees seeking to claim the deduction. Mistakes can create administrative burdens for both employers and employees which may require corrected reporting.

Key Risks for Employers

• Failure to accurately report qualified overtime compensation on Form W-2 may result in IRS information return and payee statement penalties. For returns due in 2026, penalties range from $60 to $680 per return, depending on the nature and timing of the correction.
• Intentional disregard of information reporting requirements may result in higher liability because IRS rules do not provide a maximum penalty cap these violations.
• Incorrect reporting may require employers to issue corrected Forms W-2 (Form W-2c) and may delay employees’ ability to claim the full qualified overtime compensation deduction.

Source References

• IRS Press Release – IRS updates FAQs on qualified overtime deduction
• IRS – FS-2026-13
• IRS – FS-2026-01 – FAQs
• IRS – Reliance Page – General overview of taxpayer reliance on guidance published in the Internal Revenue Bulletin and FAQs

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