One Big Beautiful Bill Update: Treasury and IRS Issue New Guidance on Overtime Deduction and Paid Family and Medical Leave Credit
Part of a series | The One Big Beautiful Bill Act Series
Treasury and the IRS have issued new guidance on the new deduction for qualified overtime compensation and changes made to the employer tax credit for paid family and medical leave.
The Treasury Department and IRS have issued Fact Sheet 2026-13 (FAQs) and Notice 2026-28, providing guidance on the new deduction for qualified overtime compensation and changes made to the employer tax credit for paid family and medical leave (PFML). The One Big Beautiful Act (the “Act”) created the qualified overtime deduction and made permanent and expanded the PFML credit.
Qualified Overtime Deduction
Background
The Act included a federal income tax deduction for qualified overtime compensation, effective for tax years 2025 through 2028. "Qualified overtime compensation" is defined as the premium portion of overtime compensation required to be paid under Section 7 of the Fair Labor Standards Act (FLSA). For example, if an individual is paid $10 per hour for non-overtime earnings, and $15 per hour for overtime, the $5 per hour premium pay for overtime is eligible for the new tax deduction.
Overtime eligible for the deduction is limited to $12,500 (or $25,000, for married filing jointly). The deduction is available regardless of whether an individual chooses to itemize deductions or take the standard deduction, and phases out beginning when an individual's modified adjusted gross income (MAGI) exceeds $150,000 for the year (or $300,000, for married filing jointly).
The deduction applies to federal income taxes, so individuals and employers remain responsible for deducting and paying applicable Medicare and Social Security taxes with respect to qualified overtime.
Treasury and the IRS previously issued transition guidance to be used by companies and individuals for the 2025 tax year.
What Fact Sheet 2026-13 Addresses
The FAQs update and replace an earlier fact sheet (Fact Sheet 2026-01) addressing the deduction for qualified overtime. The FAQs deleted information that related only to the 2025 transition year and provide employers, companies, and individuals with additional information regarding the definition of qualified overtime, eligibility for the deduction, tax withholding obligations, and reporting and correcting qualified overtime on year-end tax forms. In addition, the FAQs provide specific guidance for federal employees seeking to take the qualified overtime deduction.
Employee and Business Owner Eligibility for Qualified Overtime Deduction
To deduct qualified overtime, an employee must be covered by the FLSA and must not qualify for one of its overtime exemptions, such as for certain executives, administrators and professionals. The FAQs provide links to existing guidance provided by the Department of Labor to assist with this determination.
The FAQs also clarify that business owners who own at least 20% of their business and actively participate in its management generally are not eligible to deduct qualified overtime because they are treated as exempt executive employees under the FLSA. Individuals who own less than 20% of their business could be eligible for the overtime deduction assuming they are not covered by a separate FLSA exemption.
Independent Contractor Eligibility for Qualified Overtime Deduction
Under the Act, independent contractors are also eligible to deduct qualified overtime from their federal income tax returns. However, because the Act limits qualified overtime to overtime required under Section 7 of the FLSA, which generally does not apply to independent contractors, there was an open question as to when an independent contractor would receive qualified overtime.
The FAQs provide important clarity by stating that independent contractors would only receive qualified overtime if they are considered employees under the FLSA, while being classified as an independent contractor under the Internal Revenue Code, a circumstance the FAQs note would be “rare.” Payors and individuals should consult with their tax advisors for more information to determine if overtime paid to an independent contractor will qualify for deduction.
Federal Income Tax Withholding
The FAQs clarify that overtime, including any qualified overtime, is not excluded from taxable wages, and therefore remains subject to federal income tax withholding. Employees who seek to adjust their withholding in anticipation of taking the qualified overtime deduction on their personal income tax return must provide their employer with an updated Form W-4. The 2026 Form W-4 was updated to allow employees to include the qualified overtime deduction when calculating their withholding. Employees can also use the IRS’s Tax Withholding Estimator to help calculate withholding adjustments.
Calculation of Qualified Overtime
The FAQs reiterate the requirement from the Act that qualified overtime is limited to the premium portion of overtime required under Section 7 of the FLSA. Other types of overtime, including overtime required by state law or a collective bargaining agreement, or overtime paid voluntarily by employers, are not qualified overtime and are not eligible for deduction, unless the hours otherwise qualify under the FLSA
For employers who pay multiple types of overtime, the FAQs state that the qualified overtime portion can be calculated as (i) FLSA hours worked over 40 in a workweek, multiplied by (ii) one-half (for the premium portion), multiplied by (iii) the employee’s FLSA regular rate of pay. The FAQs also include links to existing Department of Labor guidance to assist with the calculation.
The FAQs also provide guidance to help employers calculate qualified overtime where overtime is paid using an alternate method, such as for employees of hospitals and certain residential care facilities, state and local employees, certain fire and law enforcement employees, and for public sector employees who receive compensatory time off (or comp time) in lieu of overtime.
Reporting and Correcting Qualified Overtime
For the first year of the deduction in 2025, employers and payors were not required to include qualified overtime on year-end tax forms, including Form W-2, Form 1099-MISC, or Form 1099-NEC. Beginning in 2026, these amounts must be included on year-end tax forms for individuals to claim the qualified overtime deduction on their federal income tax return. Year-end tax forms have been updated to require qualified overtime reporting on Form W-2, Box 12 (Code TT), Form 1099-MISC (Box 14) and Form 1099-NEC (Box 1d).
The amount of qualified overtime included on year-end tax forms may exceed the amount that is ultimately deductible. When filing federal income tax returns, individuals are instructed to use Schedule 1-A to calculate the deduction for qualified overtime, taking into account the overall limit of the deduction and their MAGI. (The 2026 Schedule 1-A has not yet been published.)
Employers are required to correct Forms W-2 that have inaccurate amounts of qualified overtime by issuing and filing a Form W-2c and may be subject to information reporting penalties if inaccurate amounts are not corrected. Employees can only deduct qualified overtime that appears on their Form W-2 and must contact their employer if they believe the qualified overtime on their Form W-2 is incorrect.
Guidance for Federal Employees
The FAQs also include guidance specific to federal employees to assist with the qualified overtime deductions. This guidance includes directions to support federal employees with identifying whether overtime is required under the FLSA (and is therefore eligible to be deducted). The FAQs also instruct federal employees regarding how to calculate qualified overtime under the FLSA and regulations issued by the federal Office of Personnel Management (OPM), including situations where federal employees receive compensatory time off in lieu of overtime.
Looking Ahead
The FAQs provide clarity for employers, payors, and individuals on a number of issues related to eligibility for the qualified overtime deduction and the calculation and reporting of qualified overtime amounts. Employers and payors should continue to monitor for additional guidance and work with their payroll service providers to prepare for reporting qualified overtime on 2026 year-end tax forms. In addition, employers and payors should communicate with their employees and payees regarding the limits of the deduction – specifically, that it is available almost exclusively to employees, rather than independent contractors, applies to only FLSA overtime and includes only the premium portion of that overtime – to avoid confusion and questions at year-end and during the 2026 tax filing season.
Paid Family and Medical Leave Tax Credit
Background
The Treasury and IRS guidance also addressed the expanded Paid Family and Medical Leave (PFML) tax credit under Internal Revenue Code Section 45S, providing guidance related to the provisions of the Act which made the credit permanent and expanded its availability to additional employers and employees. The guidance is intended to help employers apply the revised credit rules while Treasury and the IRS develop more comprehensive regulations.
What Notice 2026-28 Does
IRS Notice 2026-28 establishes rules allowing employers to claim the PFML tax credit based on qualifying PFML insurance premiums, rather than only on wages paid to employees while on leave. This may be of particular relevance for employers that provide PFML benefits through insured arrangements.
The guidance addresses how employers determine the amount of creditable premiums when an insurance policy provides benefits in addition to paid family and medical leave. In those circumstances, employers may claim the credit only on the portion of premiums attributable to qualifying PFML benefits and must use a reasonable allocation methodology that is supported by appropriate records and applied consistently.
For employers operating in states with mandatory paid leave programs, the guidance addresses how those state requirements interact with the federal PFML tax credit. While state mandated leave may help an employer qualify for the federal credit, employers generally cannot claim the federal tax credit on benefits required under state or local law, meaning the credit is generally available only with respect to benefits provided beyond applicable state or local mandates. For example, if a state requires eight weeks of paid leave and an employer voluntarily provides twelve weeks, the federal credit is generally available only with respect to the four weeks of leave provided beyond the state mandate.
The notice also addresses the expansion of the credit to employees with as little as six months of service and certain part-time employees working at least 20 hours per week.
Looking Ahead
Treasury and the IRS indicated that additional regulations are forthcoming and that Notice 2026-28 is intended to provide interim rules while broader implementation guidance is developed. Future guidance is expected to address additional operational, reporting, and compliance questions associated with the permanent expansion of the PFML credit. As implementation of the expanded credit continues, employers should monitor future developments and evaluate any potential impact on their paid leave programs. As always, ADP will continue to keep you informed regarding additional guidance and regulatory developments in this area.
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Updated on August 13, 2026
