IRS Overhauls Overtime Deduction Guidance: What Employers and Employees Need to Know Before Year-End

On August 6, 2026, the IRS released Fact Sheet FS-2026-13, a substantially revised set of frequently asked questions on the deduction for qualified overtime compensation. The update supersedes the guidance issued in January 2026 and adds meaningful detail on reporting, withholding, eligibility, and federal employee issues.

If you have been waiting for the practical mechanics of this deduction to come into focus, this is the guidance that does it. It also contains at least one provision that will surprise a number of business owners.

Start Here: What the Deduction Actually Covers

The deduction applies to qualified overtime compensation required under the Fair Labor Standards Act (FLSA). It is not a deduction for your entire overtime paycheck.

In most cases, only the premium portion qualifies - the amount paid above the employee’s regular rate of pay. If an employee earns $20 per hour and receives time-and-a-half for overtime, the qualifying amount is generally the extra $10 per hour, not the full $30.

Two related points that generate a disproportionate number of questions:

• FLSA overtime is measured weekly, against the 40-hour standard. Overtime that an employer pays beyond what the FLSA requires does not qualify.
• Daily overtime, double time, contractual premiums, and shift differentials fall outside the deduction. If a state law, union contract, or company policy is the source of the premium rather than the FLSA, it does not count.

Equally important is what the deduction does not do. The IRS was explicit on this point: the deduction does not exclude overtime compensation from gross income. Overtime remains fully taxable wages, subject to income tax withholding, Social Security, Medicare, and federal unemployment taxes. The relief comes as a deduction on the return, not as tax-free pay.

Deduction Limits

Eligible taxpayers may deduct up to:

• $12,500 per year for a single filer
• $25,000 per year on a joint return

The deduction begins to phase out once modified adjusted gross income exceeds $150,000 for single filers or $300,000 for joint filers and is reduced as income rises above those thresholds.

Two mechanical points worth noting: the deduction is available to taxpayers who do not itemize, and married taxpayers must file jointly to claim it. A valid Social Security number is required.

The Change Business Owners Need to See: The 20% Employee-Owner Rule

The most consequential addition in the updated FAQs is a new provision addressing employee-owners.

An employee who owns at least a bona fide 20% equity interest in a business and is actively engaged in managing that business is generally exempt from the FLSA’s overtime requirements. Because the deduction reaches only FLSA-required overtime, that individual is not eligible for the deduction.

For closely held businesses, this is the headline. S corporation shareholder-employees, LLC member-managers, and family business owners who assumed this deduction was available to them should revisit that assumption now rather than at filing time.

New for 2026: Reporting Drives Everything

Beginning with tax year 2026, employers must separately report qualified overtime compensation on Form W-2, box 12, using code TT. In limited circumstances - where a worker is an employee for FLSA purposes but treated as an independent contractor for tax purposes - reporting instead appears on Form 1099-MISC (box 14) or Form 1099-NEC (box 1d).

Three consequences follow, and each one matters:

1. The W-2 is the gatekeeper. Employees generally may claim the deduction only for qualified overtime compensation reported in box 12, code TT. If it is not on the form, it is not deductible. The transition relief that applied for tax year 2025 is gone.
2. Understatements require a Form W-2c. If an employer reports too little, the employee must obtain a corrected Form W-2c before claiming the larger amount. A tax preparer cannot simply substitute the correct figure on the return. Employers who discover a reporting error are required to file Form W-2c and furnish the corrected form to the employee.
3. Form 4852 is not a workaround. The IRS specifically addressed this: a substitute Form W-2 may not be used to claim additional deductible overtime compensation that the employer did not report. The fix runs through the employer, not around it.

Report the full amount of qualified overtime compensation paid, even where the employee will not be able to deduct all of it because of the dollar limits or the income phaseout. An employee paid $30,000 in qualified overtime still gets $30,000 reported in box 12, code TT.

Withholding Stays Put

Employers must continue withholding federal income tax from overtime wages and may not reduce withholding on their own initiative because an employee expects to qualify for the deduction.

Employees who want their withholding to reflect the anticipated deduction should submit an updated Form W-4. That is the appropriate mechanism, and it is a conversation worth having with your payroll team now rather than in the spring.

Who Is and Is Not Covered

To qualify, an employee must be covered by the FLSA and not exempt from its overtime rules. The updated FAQs expand the discussion of exempt categories, which commonly include certain executive, administrative, professional, outside sales, computer, agricultural, transportation, and seasonal employees, along with railroad and airline employees subject to separate rules.

Many hourly workers - including police officers, firefighters, and a range of healthcare employees - generally do qualify.

Federal employees received an expanded section of their own, developed in coordination with the Department of Labor and the Office of Personnel Management, covering FLSA overtime eligibility, compensatory time, work periods, hours worked, and regular-rate calculations under OPM regulations. A practical marker: FLSA status is typically documented on Standard Form 50, Notification of Personnel Action, at block 35. An “E” indicates exempt and ineligible; an “N” indicates nonexempt and overtime-eligible.

The IRS also added detail on how employers should calculate qualified overtime compensation, including workweek definitions, hours worked, regular-rate calculations, alternative overtime computation methods, and compensatory time arrangements available to certain state and local government employees.

Action Items

Employers should:

• Confirm payroll systems can isolate the FLSA premium portion of overtime and report it in box 12, code TT for 2026
• Review employee-owner classifications against the 20% equity and active management standard
• Establish a process for identifying reporting errors and issuing Forms W-2c
• Leave withholding practices unchanged and direct employees to Form W-4

Employees should:

• Confirm that overtime appears in box 12, code TT on the 2026 Form W-2
• Request a corrected Form W-2c promptly if the reported amount looks wrong
• Consider a revised Form W-4 if withholding should reflect the expected deduction

One Note of Caution

These are FAQs, not regulations. They provide reasonable-cause penalty protection for taxpayers who rely on them, but they are not precedential authority, and the IRS can revise them - as it just did to the January version. Positions built on this guidance should be documented with that in mind.

Written By: Mark S. Gallegos, CPA, MST | Tax & Advisory Partner, Porte Brown LLC