There has been some confusion among employers regarding the “One Big Beautiful Bill.” Despite the shorthand references to “no tax on overtime” and “no tax on tips,” the law does not eliminate payroll taxes or change how employers calculate or pay overtime. Instead, it creates a temporary “individual income tax deduction” for employees, which in turn triggers new (and evolving) employer reporting obligations.
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No Change to Overtime Pay Obligations
Employers must continue paying overtime exactly as required under federal and state law. Under the federal Fair Labor Standards Act (FLSA), nonexempt employees must receive overtime at one-and-one-half times their regular rate of pay for all hours worked over 40 in a workweek. In California, nonexempt employees are entitled to overtime at 1.5 times their regular rate for (i) hours worked in excess of 8 hours up to and including 12 hours in a workday, (ii) hours worked over 40 in a workweek, and (iii) the first 8 hours worked on the seventh consecutive day in a workweek. Double time (2.0 times the regular rate) is required for (i) hours worked over 12 in a workday and (ii) hours worked over 8 on the seventh consecutive day in a workweek.
The new federal tax deduction does not alter an employer’s overtime pay obligations. Instead, it allows for a temporary deduction for eligible employees regarding the FLSA-required overtime premium portion (the additional 0.5 above the regular rate for hours over 40 in a workweek). Overtime or double time that was paid to an employee solely because of California (or another state’s) law does not independently qualify for the federal deduction. The annual deduction is capped at $12,500 ($25,000 for married employees filing jointly) and phases out for individuals with modified adjusted gross income above certain thresholds.
No Change to Payroll Tax Withholding
Importantly, employers must continue withholding and remitting federal income tax, Social Security, and Medicare taxes on overtime and tips as usual. The law does not create a payroll-level exemption. The benefit is realized by employees when they file their individual tax returns. Employers should ensure payroll teams understand that nothing changes operationally with respect to withholding.
Anticipated Separate Reporting
Beginning with tax year 2026 (forms issued in early 2027), employers are expected to separately report qualified overtime premium amounts and qualified tips on revised Forms W-2 and other applicable information returns. Employers should work now with their payroll providers to ensure systems can track: (i) the FLSA overtime premium portion separately from base wages, and (ii) tip income consistent with existing federal reporting rules. Advance system configuration will reduce compliance risk once the IRS finalizes reporting instructions.
Practical Compliance Steps
Employers should (a) confirm payroll systems can distinguish the FLSA overtime premium from state-law required overtime amounts; (b) communicate internally that withholding rules remain unchanged; (c) monitor IRS guidance and form revisions; and (d) avoid making employee-facing statements suggesting overtime or tips are “tax-free.” Employers may receive additional questions from employees during the upcoming tax season about what amounts may qualify. Employers should exercise caution in providing specific “deduction” amounts to employees and/or providing tax advice, and if needed, should direct employees to consult with their personal tax advisors. Mischaracterizing the deduction could create employee-relations issues and wage-claim liability. As always, multi-state employers should carefully review state overtime rules to avoid errors when calculating and reporting qualified overtime premium amounts.
If you would like assistance reviewing payroll processes, employee communications, or state overtime rules in light of the new law, please let us know.
Authors: June Monroe is a director in Fennemore’s Orange County office and a member of the firm’s Labor & Employment Law Practice Group. June advises employers on compliance, investigations, and litigation defense. She represents companies before the U.S. Department of Labor, the California Labor Commissioner, and state and federal court, and has successfully defended wage and hour, discrimination, and unemployment benefit claims. She can be reached at jmonroe@fennemorelaw.com. Elise O’Brien is a director in our Orange County office who works in our Labor & Employment practice group. Elise has extensive experience representing employers in federal and state court litigation involving wrongful termination, discrimination, harassment, retaliation, and wage and hour claims. She can be reached at eobrien@fennemorelaw.com. David Sieck is an associate attorney within Fennemore’s Labor & Employment and Employee Benefits practice groups. His practice focuses on advising employers on all scopes of employment and employee benefit matters. He can be reached at dsieck@fennemorelaw.com.
