Your payroll team isn’t imagining things. The Big Beautiful Bill Act’s overtime tax provision really is as confusing as it seems. Government finance officers, payroll professionals and business owners across industries are all asking the same question: What exactly do we need to track for 2025?
The confusion is understandable. Congress created a retroactive tax deduction for employees while leaving employers to figure out compliance with incomplete guidance. Here’s what you need to know to stay compliant and avoid penalties.
The Compliance Gap Creating Chaos
The BBB overtime provision took effect January 1, 2025, but formal W-2 reporting changes don’t begin until 2026. The IRS announced in August that current payroll forms will remain unchanged for 2025, creating a gap where employee tax benefits exist without clear employer reporting requirements.
For 2025, employers can use “any reasonable method specified by the IRS” to track qualified overtime compensation. The problem? The IRS hasn’t published those reasonable methods yet, leaving employers guessing about compliance standards.
This uncertainty carries real consequences. Incorrect reporting could trigger payroll tax audits, employee disputes over W-2 accuracy, or penalties for failing to meet documentation requirements when formal reporting begins in 2026.
What Qualifies and What Doesn’t
The BBB Act allows employees to deduct qualified overtime compensation from federal taxable income (up to $12,500 for single filers or $25,000 for joint filers). The deduction phases out starting at $150,000 in modified adjusted gross income.
Only the premium portion of Fair Labor Standards Act-required overtime qualifies. An employee earning $20 per hour regular time and $30 per hour overtime can deduct only the $10 premium portion.
This creates tracking complexity because state-mandated overtime (like California’s daily overtime) doesn’t qualify. Neither do voluntary overtime premiums beyond FLSA requirements or overtime for exempt employees reclassified to capture the deduction.
Critical limitation: The deduction applies only to federal income tax. Employees still owe full Social Security, Medicare, and state taxes on all overtime compensation.
Current Compliance Requirements
Employers face immediate obligations regardless of the guidance gap. So what do you do?
- Continue standard withholding: Withhold federal income tax from all overtime pay. Employees receive the benefit when filing returns, not through reduced withholding or refunds or reimbursements by employers to employees
- Track FLSA premium separately: Document the premium portion of FLSA-required overtime distinct from regular wages and state-mandated overtime. Your payroll system likely tracks overtime already, but you may need new data mapping to isolate qualifying amounts.
- Document your tracking method: Whatever approach you use for 2025, maintain detailed records of calculations and rationale. The IRS will require this documentation when formal reporting begins in 2026.
- Prepare for employee questions: Workers expect immediate tax relief but won’t see benefits until filing 2025 returns in early 2026. Clear communication prevents confusion and potential disputes.
State Tax Complications
Federal tax relief doesn’t extend automatically to state taxes, creating compliance challenges for multi-state employers. Four states: Alabama, Kentucky, North Carolina and Nebraska have enacted or proposed legislation exempting overtime income from state tax. The remaining 46 states haven’t acted, meaning overtime remains fully taxable at the state level.
This disparity creates reporting complexity. Employees may owe federal tax on $50,000 in overtime but state tax on the full amount. Multi-state employers must track different tax treatments by location and monitor evolving state legislation.
Without clear guidance on state form modifications, employers should maintain detailed records showing federal versus state taxable overtime amounts by employee and location.
Preparing for 2026 Changes
Starting in 2026, employers must report qualified overtime compensation as a separate W-2 line item. The IRS is developing new forms and guidance, but employers should begin preparation now.
System modifications may be required to capture and report qualifying overtime properly. Many payroll systems track overtime for other purposes, so additional reporting may require configuration changes rather than complete overhauls. Early planning helps budget for modifications and ensures smooth implementation.
The key is building tracking capabilities that satisfy both current documentation requirements and upcoming formal reporting obligations.
Year-End Action Items
With 2025 year-end approaching, prioritize these steps:
- Review your current overtime tracking to ensure you can separate FLSA-required premium amounts from regular wages and non-qualifying overtime premiums.
- Document your 2025 tracking methodology clearly, including calculations for the premium portion of qualifying overtime by employee.
- Monitor IRS announcements for specific reasonable method guidance and 2026 reporting requirements.
- Assess state tax implications for your operating locations, particularly if you have employees in multiple states with different overtime tax treatments.
- Communicate with employees about the tax implications, emphasizing that overtime remains fully taxable for withholding purposes and they’ll need professional tax guidance to claim deductions.
The Bottom Line
The BBB overtime provision creates immediate compliance obligations despite incomplete guidance. Employers who document their tracking methodology thoroughly and prepare for 2026 formal requirements will avoid penalties and position themselves for smooth implementation.
The retroactive nature of this law means decisions you make now about tracking and documentation will affect your compliance through 2028. Getting it right from the start is crucial.
Need help developing compliant overtime tracking methods and preparing for 2026 reporting changes? Rea’s tax professionals specialize in helping employers understand complex tax law changes and implement practical compliance solutions that work in the real world.
