Federal “Qualified Overtime” Tax Deduction: What Contractors Need to Know

What the Law Does

The new provision allows employees to deduct certain overtime compensation from their federal taxable income on their individual tax returns.

This is a federal income tax deduction. It does not eliminate overtime wages. It does not eliminate payroll taxes. It does not change prevailing wage requirements. It does not change union contracts.

It allows eligible employees to deduct the qualifying overtime premium portion of their pay when they file their federal income tax return.

What Counts as “Qualified Overtime”

Under IRS guidance, “qualified overtime” is narrowly defined. It includes only the overtime premium required under the Fair Labor Standards Act, meaning the additional half-time portion paid for hours worked over 40 in a workweek.

For example: If an employee earns time and one-half, the “half” premium portion is what qualifies.

It does not include:
• Daily overtime required by state law
• Double time
• Holiday pay
• Contractually required overtime under a collective bargaining agreement if it exceeds FLSA requirements
• Shift differentials

This distinction is important for union contractors whose CBAs may include overtime provisions beyond federal law.

Employer Reporting Requirements

For tax year 2025:

• Employers are not required to separately report qualified overtime on Form W-2. The IRS has indicated this is a transition year.
• Employers may voluntarily provide information to employees regarding qualifying overtime amounts, but it is not mandatory.

Beginning in tax year 2026:

• Employers will be required to separately report qualified overtime compensation on Form W-2.
• Contractors should begin preparing payroll systems to track the FLSA-required overtime premium separately from other premium pay categories.

What This Means for Contractors

This provision primarily affects employees’ personal tax returns, not contractor tax liability.

However, contractors should consider:

• Whether payroll systems can distinguish FLSA overtime premium from other premium categories
• Whether payroll vendors are preparing for 2026 reporting changes
• Whether internal accounting codes need refinement
• How to communicate clearly with employees to avoid confusion

It is important not to assume that all overtime is tax-free. Only the defined premium portion may qualify for deduction on the employee side.

What This Does Not Change

This federal deduction does not:

• Change prevailing wage laws
• Change overtime requirements under CBAs
• Change employer payroll tax obligations
• Eliminate FICA or Medicare tax
• Automatically reduce withholding in 2025

Employees should consult their personal tax advisor for specific guidance.

SMCA Will Continue to Monitor

SMCA will continue to monitor IRS implementation guidance and provide updates as additional clarification becomes available, particularly as the 2026 W-2 reporting requirement approaches.

If you have questions about how this may affect your payroll operations, consult your CPA, payroll provider, or labor counsel.