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Tax and Overtime: Thank Goodness for Payroll Providers
Editor's Note
Tax and Overtime: Thank Goodness for Payroll Providers
After HR 1, aka OBBBA, employees are kinda sorta not taxed on overtime wages. Except that Congress can't regulate state overtime. And it's the middle of the year and the rules are changing. So it's going to work as a tax deduction, but only for federal overtime wages.
Here's why it's a flipping nightmare. In California, overtime is anything over eight hours in a day OR 40 hours in a week. If a nonexempt employee works a ten hour day, they are entitled to 2 hours OT under California law.
But federal overtime under the Fair Labor Standards Act is work over 40 hours per week. So if that same employee who just finished a ten hour day only works 40 hours for the week, there's no federal overtime.
The new law does not apply to those two hours of California overtime and it gets taxed as income.
Now suppose that the employee works 5 ten hour days for a total of 50 hours that week. They would be entitled to two hours for each ten hour day or 10 hours of OT under CA law and because they had a 50 hour week, they would also be entitled to 10 hours under federal law. So those match up.
Then there's seventh day OT and double time under state law that can still be time and half, only it applies to fewer hours under federal law. It gets to be a complete cluster fast.
At the end of the year, someone now also has to figure out whether and how much federal overtime pay the employee received (even if it was calculated under more expansive state rules).
But there is someone who can save you. It's your friendly, reliable payroll provider who knows what they are doing, has the resources to stay up to date on the latest changes. They will handle it all for you and even provide information for you to explain it to your employees. If you don't have someone like this, it's time to start looking. It's worth the time.
In the meantime, here's more on how the new law on taxing overtime works.
- Heather Bussing
by Michael Ryan
One of the fastest trending topics in the employment and taxation blogosphere in recent weeks has been the passage of the One Big Beautiful Bill Act (OBBBA), which, among other provisions, allows for a tax deduction of up to $12,500 ($25,000 for joint filers) in “qualified overtime compensation.”
The fact that the OBBBA provides for a tax deduction can be interpreted as good news for employers in the short term, because it means they are not required to immediately change withholding amounts on a paycheck-by-paycheck basis. Rather, employers will have to record and report qualifying overtime compensation on employees’ end of year tax forms. This means that the primary thing employers need to carefully assess right now is their time tracking and recordkeeping systems to ensure they can satisfy the new reporting requirements at year’s end.
You may be asking yourself, “how hard could that be?” Well, a potentially overlooked aspect of the OBBBA looms large on this point: what overtime compensation actually “qualifies” for the deduction?
The answer to that question is surprisingly nuanced, so let’s break it down.
The OBBBA, as a federal law, does not and cannot exempt overtime wages from all taxes; it can only impact employees’ federal taxes. This is precisely why the OBBBA defines overtime that “qualifies” for the deduction to be overtime wages “as defined by Section 7 of the Fair Labor Standards Act of 1938.” This definition creates two primary carve-outs, meaning employers: (1) in states with state and local taxes on overtime wages; and/or (2) who voluntarily pay a higher overtime rate than is required by the FLSA (e.g., double-time), need to be able to differentiate between — and properly track — overtime that does qualify for the OBBBA deduction and overtime that does not.
Taking this a step further, some states have directly addressed the taxation issue in recent months given the possibility — and now the certainty — of the OBBBA’s passage, whereas others have remained silent on the issue. One example of a state that has addressed the taxation equation is Colorado, which passed H.B. 1296 in May 2025. The Colorado law provides that any overtime income that might in the future be exempted from federal taxable income will still be taxed at the state level. Interestingly, Colorado now has legislation pending to effectively reverse this policy, but that new legislation won’t be put to vote until November 2026.
The takeaway from this dueling legislation in Colorado is that employers need to be assessing the state and local tax requirements in the states in which they operate to ensure their end-of-year tax records correctly align with their state and federal taxation reporting requirements for employees’ qualifying and non-qualifying overtime wages.
For many employers, their internal policies — much like the recordkeeping requirements themselves — have not been adjusted in years, but the OBBBA has now ushered in a new recordkeeping paradigm. Therefore, there is no time like the present for employers to review their policies, address gaps in how overtime hours are being tracked for federal and state purposes under the new recordkeeping and reporting requirements, and consult with their tax and employment counsel, all to ensure that the One Big Beautiful Bill doesn’t quickly turn into the One Big End-of-Year Paperwork Nightmare.
