Public Employers Face Major Shift in Payroll Tracking due to One Big Beautiful Bill’s FLSA Overtime Tax Deduction

12.10.2025

Public employers will turn to the new federal overtime tax deductions provided under the One Big Beautiful Bill Act (“OBBBA”), as the end of Tax Year (“TY”) 2025 approaches. The OBBBA introduced a significant new tax deduction for employees who receive overtime required by federal law, aimed at lowering taxable income for employees.  The bill went into effect earlier this year with retroactive application to January 1, 2025; it will remain in place through December 31, 2028 (unless extended).

Public employers should not only consider the impact of this new tax deduction on how they prepare W-2 forms for employees for TY 2025, but how they should adapt or modify payroll practices to align with the OBBBA’s provisions.  This alert summarizes how the OBBBA intersects with existing federal wage and hour law, and how public employers should evaluate their compliance efforts.

Overview of FLSA Requirements

The OBBBA allows employees to claim a new tax deduction for “overtime compensation… required under Section 7 of the Fair Labor Standards Act.” (26 USC § 225(c)(1).) Thus, in order to appreciate the scope of this new tax deduction, public employers must ensure they are familiar with what qualifies as overtime required by the FLSA.

Section 7 of the FLSA contains specific and limited overtime requirements. The general rule is that employers must compensate non-exempt employees who work more than 40 hours in a 7-day workweek at a rate of 1.5 times their regular rate. (29 USC § 207(a)(1).) This is known as standard “weekly overtime”, or FLSA overtime. Section 7 contains several exceptions to the standard weekly overtime rule. For instance, public employers may set a different workweek for public safety personnel, which would increase the hourly threshold for when those employees must be paid overtime. Under subsection (k) of Section 7, an employer may set an “alternative workweek” for purposes of overtime for qualifying law enforcement and fire suppression personnel, such that those employees may work more than 40 hours before they are entitled to overtime. (29 USC § 207(k).) The “alternative workweek” may be set for 7 to 28 calendar days, with the overtime hours threshold proportionately increasing depending on the particular workweek selected. For example, if an employer set the workweek for fire personnel at 28 days, the employer must pay employees overtime (1.5 times their regular rate of pay) if they work more than 212 hours in that 28-day period.  The FLSA includes other, limited exceptions concerning how overtime may be paid.[1]

In sum, weekly overtime (whether a 7-day or alternative workweek) is required by the FLSA, and would qualify for the new OBBBA tax deduction.

However, there are other forms of compensation which are not required by section 7 of the FLSA, which fall outside this new tax deduction.  The following list summarizes the most common forms of compensation which are not required by the FLSA:

• Daily overtime: employers may pay employees overtime if they work more than 8 hours in a single day. While state law requires private employers to provide daily overtime, the FLSA does not. (See Dairies, Inc. v. RSUI Indemnity Co., 617 F.Supp.2d 1023, 1041 (E.D. Cal. 2009) (comparing state and federal law as to daily overtime).) Notably, public employers are exempt from the state daily overtime rule found in Section 510 of the Labor. (Johnson v. Arvin-Edison Water Storage District (2009) 174 Cal.App.4th 729.)
• Double overtime: employers may pay employees overtime at a higher rate of pay (2 times their regular rate of pay) if employees work more than 12 hours in a day, or more than 8 hours in a day for seven consecutive days. Section 510 of the Labor Code also contains this double overtime rule. However, the FLSA does not require double time.
• Overtime for Exempt employees: employers may choose to allow exempt employees to earn overtime pay, in spite of their classification as an exempt employee. This may be done as a policy measure for various reasons, and may be contained in a policy, employment contract, or simply be done as an unwritten practice. Regardless of the motivation for it, or the underlying policy basis, the FLSA does not require it; in fact, the primary purpose of classifying an employee as exempt is for the employer to forgo paying that employee overtime.
• Regular rate calculations: the FLSA requires that employers pay weekly overtime at a specific rate of pay, that is, 1.5 times an employee’s “regular rate.” Courts and federal agencies have clarified that some forms of pay must be included in “regular rate”, which would thus be included in FLSA-required weekly overtime, while other forms of pay do not need to be included in “regular rate.” This second category of pay that need not be included in regular rate includes the following:
  • Holiday pay; paid sick leave; vacation leave; payments to retirement trustee, life, or health insurance administrators; discretionary bonuses; cash-outs if accrued paid sick leave; and gifts.

If an employer chooses to include these forms of pay in an employee’s regular rate, and then uses this higher regular rate figure to calculate an employee’s overtime rate, the employer is paying employees overtime at a higher rate than is required by the FLSA.

• Hours worked: the FLSA requires that employers pay weekly overtime for all “hours worked” over 40; “hours worked” does not include time in which an employee did not engage in work for the employer. Thus, in calculating if an employee is entitled to overtime under the FLSA, employers do not need to include time spent using paid sick leave, vacation leave, or other forms of leave. Some employers choose (whether due to a negotiated MOU or otherwise) to include such hours when calculating weekly overtime. If an employer makes that choice, and pays an employee weekly overtime despite the employee e.g. using 16 hours of paid sick leave in that week rather than working, the employer has paid the employee overtime which is not required by the FLSA.

In sum, employers may choose to pay employees overtime under a variety of circumstances which are not required by the FLSA. Whether an employer chooses to pay employees as outlined above (or count hours for OT purposes as described above) as a matter of policy, unwritten practice, or based on a contractual agreement, these decisions are voluntary – and not required by federal law.  This includes a collective bargaining agreement reached between a public employer and a recognized union. Even if a public employer is required to compensate employees due to the provisions of a labor MOU, the employer must consider whether the MOU simply mirrors what the FLSA requires – or goes beyond federal law in one of the areas listed above. In the event of the latter, such compensation is known as “MOU overtime” and would not be eligible for the tax deduction provided by the OBBBA.

It remains critical for public employers to be aware of the differences between overtime required by the FLSA, and other forms of overtime which are not. As detailed below, public employers should track various forms of compensation to ensure they can differentiate between overtime required by the FLSA (which would be eligible for a OBBBA tax deduction) and all other forms of compensation.  In policing the deductions taken by employees based on employer-prepared W-2s, the IRS will expect public employers to take compliance actions with respect to the OBBBA based on this common understanding of what the FLSA requires (and does not).

OBBBA Overview

The OBBBA’s tax deduction is subject to caps of $12,500 for single filers and $25,000 for joint filers, with phase-outs for higher-income earners – that is, individual filers with an adjusted gross income (“AGI”) above $150,000, or joint filers with an AGI above $300,000. The OBBBA specifies how this phase-out functions – namely, that the deduction be reduced $100 for every $1,000 that the tax filer’s AGI exceeds the $150K and $300K respective caps. (26 U.S.C. § 225(b)(2)(A).)  Correspondingly, the deduction is eliminated at $275,000 for single filers and $550,00 for joint filers.[2]

The following examples may help demonstrate how the phase-out policy applies:

“Example 1. Emily, a warehouse employee, earns $22/hr. and works 120 overtime hours at $33/hr. The overtime premium is $11/hr. x 120 hours, totaling $1,320. Her MAGI is $85,000; therefore, the full $1,320 is deductible.

Example 2. Daniel, a factory worker, earns $160,000 MAGI and has $15,000 in overtime during 2025. The maximum deduction is capped at $12,500, but if MAGI exceeds $150,000, the deduction is reduced by $1,000 due to the phase-out. Therefore, Daniel may deduct $11,500.[3]”

Compliance Efforts Moving into 2026

Public employers have two compliance decisions to consider as we approach 2026: (1) what actions to take for TY 2025, and thus for W-2s to be issued in the coming months; and (2) what actions to take for TY 2026 and going forward. The IRS has issued extensive guidance for taxpayers (and thus, as employees rely on W-2s, employers) who seek to claim the OBBBA’s federal overtime deduction[4].

Guidance on Taking Action for TY 2025

For TY 2025, the IRS has provided employers with some relief. On November 2, 2025, the IRS announced that it will not penalize employers who choose not to implement changes to their payroll and other functions to come into compliance with the OBBBA (including the deduction for federal overtime) for TY 2025[5]. The IRS reasoned:  

Employers may not currently have the information required to be reported under the OBBBA, or the systems or procedures in place to be able to correctly file the additional information with the IRS, or [Social Security Administration] in the case of a Form W-2, and provide it to employees and other payees.

Correspondingly, the IRS announced that Forms W-2 and 1099 for TY 2025 do not need to be updated to account for OBBBA-related changes. However, the IRS strongly encourages employers to act now to update implement changes and come into compliance now.

While public employers will not face a penalty if they choose not to adjust their practices and employee W-2s to account for the OBBBA’s new requirements, they should conduct a cost/benefit analysis to evaluate whether to come into compliance with the new law for TY 2025. Principally, this new FLSA overtime tax deduction offers all parties a substantial benefit. For public employees, accurate reporting of qualified overtime enables them to claim valuable deductions under the OBBBA, potentially reducing taxable income and increasing take-home pay. Conversely, public employers may face complaints and/or morale issues if public employees discover that the agency chose not to take swift action to facilitate access to this tax deduction for TY 2025.

Public employers also derive long-term benefit if they take action now to come into compliance, as it minimizes future administrative burdens, ensures readiness for mandatory reporting for TY 2026, and demonstrates a strong commitment to supporting employee financial well-being. While the IRS offers flexibility for TY 2025, taking early steps toward compliance is a valuable investment in efficiency, employee training, and accurate overtime tracking.

Guidance on Long-Term Compliance with OBBBA

Regardless of whether public employers decide to take action now for TY 2025 or not, they must implement systemic, long-terms changes or updates to their practices to comply with the OBBBA.

• Policy/Practice/Contract Review: consider how the agency pays overtime, and the source for its decisions (MOUs, policies, unwritten practices, etc.). As noted above, this review includes which hours are counted to determine when/if overtime is paid, what types of pay are included in regular rate (and thus, overtime rate) of pay, when overtime is paid (daily, double time), and who is eligible for overtime (all staff or just non-exempt employees).
• Review Current Data Tracked and Retained by Payroll System: evaluate payroll practices and/or systems to determine how the agency tabulates and codes several forms of pay, including: whether overtime is tracked and coded separately (e.g. daily overtime, standard weekly overtime, 7(k) alternative workweek overtime, etc.), and whether various forms of pay (e.g. sick leave, holiday pay, bonuses, etc.) are tracked and coded separately from base pay. This review should include a review of underlying records and/or information prepared by managers or supervisors to populate paystubs.
• Update Payroll System and/or Practices: update and/or expand payroll practices and systems to ensure that the agency records and retains the appropriate overtime data. Proper categorization ensures compliance with evolving reporting requirements and facilitates employees’ ability to claim deductions for qualified overtime compensation. This will surely require close review of how regular and overtime rates of pay are calculated, so that the agency can discern when it chooses to include forms of pay in these rates of pay which are not required by the FLSA – and separately track the lower overtime rate of pay which is required by the FLSA. Thus, even if the agency is more generous than what federal law requires, it can calculate the baseline overtime pay (based simply on weekly overtime figures and regular rate) required by the FLSA – and have accurate data to include in W-2 forms.
• Update W-2 forms: if the agency decides to act now for TY 2025, it should modify W-2 forms to list qualifying FLSA overtime in Box 14 of the W-2, or through supplemental statements to assist employees in claiming deductions. For TY 2026, the IRS has advised that it will issue subsequent guidance and forms to help employers with reporting requirements.
  • To that end, the IRS has published a draft, revised W-2 form[6] for TY 2026 with a revised Box 12 – and a draft new code for FLSA overtime to be claimed as a tax deduction (i.e. “TT”). The IRS will surely continue to work on these draft forms and instructions, so agencies are encouraged to watch for updates on this front as 2026 progresses.
• Train Staff: once these updates and/or changes have been made, the agency should train HR and payroll staff on the new IRS tax deductions. This may include developing informal, internal best practices guidelines to assist staff with complying with these new IRS guidelines. These guidelines will also serve as support for the agency to document its compliance efforts, in the event of a subsequent IRS audit.

Public employers may face challenges in conducting this review and/or implementing changes, as payroll systems are not easily modified and may require incurring substantial costs to adjust. However, it is also clear that public employers face risk if they do not ensure that they create and maintain clear payroll records which track eligible FLSA overtime, separate from other forms of compensation. The IRS has specified that employers are expected to use “reasonable methods” for calculating or approximating (if actual hours and/or data is difficult to track) overtime payments to employees which would be eligible for the OBBBA’s tax deduction.[7]

In the event a public employee claims a tax deduction based on compensation information (in an employer-prepared W-2) which the IRS suspects to be overstated and inaccurate, employers face the risk of an IRS audit. Thus, while compliance steps will surely involve expense and burdens on staff, these steps remain necessary. This risk is notably still present if a public employer chooses to take action now for TY 2025; while the IRS has clearly noted that it will not take action to penalize employers who do nothing for TY 2025, employers may well face risk if they implement changes now with overstated, inaccurate and/or poorly documented FLSA overtime figures on employee W-2s. In short, public employers should take deliberate and decisive action.

Public employers have many decisions to make in ensuring their payroll practices, policies and tax records are brought into compliance with the OBBBA.  Our firm will monitor the status of this new tax deduction as the federal government issues more guidance for TY 2025 and beyond.  We encourage public employers to reach out to the authors of this Alert to receive updates or to obtain assistance with compliance efforts.

[1] For instance, employers may also provide non-exempt employees with compensatory time off (“CTO”) instead of compensation for weekly overtime. Subsection (o) of section 7 of the FLSA allows for employers to provide employees with paid time off (at 1.5 CTO hours for each overtime hour worked) instead of providing cash compensation for weekly overtime. As CTO is another method for compensating employees for overtime under the FLSA, it would also qualify for the new OBBBA tax deduction.

[2] This hard cap for the phase-out results if a filer can claim the full deduction ($12,500 for individual filers, and $25,000 for joint filers respectively) and is a high earner. If the deduction is reduced $100 for each $1,000 that a filer’s AGI exceeds the cap, individual filers can reduce the deduction 125 times (by $100 each) before the deduction is entirely eliminated; similarly, joint filers can reduce the deduction 250 times (by $100 each) before the deduction is entirely eliminated.

[3] Various business educational institutions and private firms have supplied such practical hypotheticals illustrating how this phase-out would work. See e.g. https://taxschool.illinois.edu/post/obbba-update-qualified-tips-and-overtime-compensation-for-tax-year-2025/, last accessed December 10, 2025.

[4] See https://www.irs.gov/pub/irs-drop/n-25-69.pdf, last accessed December 10, 2025.

[5] See https://www.irs.gov/pub/irs-drop/n-25-62.pdf, last accessed December 10, 2025.

[6] Available online here - https://www.irs.gov/pub/irs-dft/fw2--dft.pdf, last accessed on December 10, 2025.

[7] See 26 U.S.C. § 225(h) (transition rule in OBBBA itself for “approximating” eligible FLSA overtime using “reasonable method”).

This AALRR publication is intended for informational purposes only and should not be relied upon in reaching a conclusion in a particular area of law. Applicability of the legal principles discussed may differ substantially in individual situations. Receipt of this or any other AALRR publication does not create an attorney-client relationship. The Firm is not responsible for inadvertent errors that may occur in the publishing process.

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