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What the New No Tax on Overtime Rules Mean for California Employers

Employee working late overtime hours at a computer in an office, illustrating FLSA overtime pay and tax reporting rules.
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The reporting relief that let employers skip separately tracking qualified overtime compensation in 2025 is gone.

Starting with tax year 2026, that reporting is no longer a courtesy for employees; it is now baked into how the deduction works, and getting it wrong on a W-2 creates exposure the business carries, not just a form to correct later.

Below, Strategy Law, LLP walks through who this touches on your payroll, where the real risk sits, and what we are telling clients to do about it before year-end processing locks in.

What Are the New 2026 IRS Overtime Reporting Requirements?

Last year's flexibility came from Notice 2025-69, and it applied to exactly one tax year.

Fact Sheet FS-2026-13, which the IRS released in August 2026 to replace its January guidance, makes clear that separate reporting is now part of how the deduction functions under the new Internal Revenue Code Section 225, created by the One Big Beautiful Bill Act.

That distinction matters more than it sounds. A business that treated 2025's relief as a preview of a permanent grace period is working from an assumption that no longer holds, and payroll systems built around last year's rules need a second look before this year's W-2s go out.

Which Employees Qualify for the FLSA Overtime Tax Deduction?

The deduction only reaches overtime required under section 7 of the Fair Labor Standards Act, so the real work for an employer is figuring out which employees are FLSA overtime-eligible in the first place.

California Payroll Note: Section 225 applies only to FLSA-required weekly overtime (hours worked over 40 in a workweek). State-mandated daily overtime, such as California's requirement to pay overtime after 8 hours in a single workday, does not qualify for the federal tax deduction unless those hours also count toward FLSA weekly overtime limits.

Several common roles fall outside FLSA overtime entirely, and the deduction never touches their pay, no matter how the business labels extra hours. This includes:

  • Executive, Administrative, and Professional Employees: This includes teachers and academic administrative staff at elementary and secondary schools, who are exempt under the same standard.
  • Outside Sales Employees: Workers whose primary duty is making sales away from the employer's place of business.
  • Certain Computer-Related Occupations: Specific technical roles that meet the FLSA's computer employee exemption criteria.
  • Other FLSA-Exempt Categories: Certain commissioned retail employees, motor carrier and transportation workers, seasonal amusement or recreational staff, and agricultural employees performing specific duties.

Employee-owners add another wrinkle. Anyone holding a 20 percent or larger stake who is actively engaged in managing the business is generally treated as an exempt executive regardless of entity type, and state or local government employees who take compensatory time off instead of cash overtime follow a different timing rule entirely, since the deduction only attaches once that time is paid out in wages.

Penalties and Risks of Reporting Errors

Once you know which employees qualify, the mechanics themselves are specific, but a few points carry real consequences if the reporting goes wrong:

  • Reporting the Right Amount: Employers report the full FLSA-required overtime premium on Form W-2, box 12, using code TT, which is the total premium paid during the year, not the smaller amount an employee may eventually be able to deduct once income limits and phaseouts apply.
  • What an Error Actually Costs: An employee generally can only claim a deduction based on what the employer reported, so a mistake in box 12 does not stay an internal accounting matter, it directly limits what the employee can deduct on their own return.
  • Correcting a Mistake: Fixing an error means filing a Form W-2c with the Social Security Administration, and incorrect or delayed corrections can trigger information-reporting penalties under the tax code.
  • The Contractor Exception: A narrow exception applies when a worker is an employee for FLSA purposes but is treated as a contractor for tax purposes, in which case the amount belongs on a 1099 instead of a W-2.

Each of these steps becomes mandatory once a worker earns FLSA-covered overtime, and establishing an accurate correction protocol is just as critical as calculating the initial figures correctly.

4 Steps for 2026 Year-End Payroll

A handful of concrete steps now cost far less than untangling a reporting error after W-2s have already gone out:

  1. Confirm FLSA Classifications First: Nothing downstream works correctly until the business knows which employees are FLSA overtime-eligible and which are exempt, including owner-employees with a meaningful equity stake.
  2. Audit Whether Payroll Can Isolate the Premium: Confirm the payroll system can separate the FLSA-required overtime premium from base pay and from any extra premium the business pays voluntarily beyond what the law requires.
  3. Build a Correction Process Before You Need One: Decide now who is responsible for catching and filing a Form W-2c if a code TT amount turns out to be wrong, since the timeline for correcting it affects penalty exposure.
  4. Get Ahead of Form W-4 Requests: Employees can ask to adjust withholding for the deduction using the 2026 Form W-4's new worksheet, and payroll should have an answer ready before the requests start coming in.

How Strategy Law, LLP Can Help

Strategy Law, LLP is a business-focused law firm serving entrepreneurs, companies, and investors throughout Silicon Valley, the Greater Bay Area, and the state of California. Since 2014, we have provided strategic, practical legal counsel to help clients address complex employment and tax planning matters with clarity and confidence.

Our work spans the full lifecycle of a business, including employment law compliance, entity formation, and financial structuring.

Talk to Our Team Before Year-End Payroll Closes

Getting overtime reporting right the first time protects your business from correction costs and protects your employees' ability to claim a deduction they are entitled to.

A reporting error discovered after W-2s go out is far more work to fix than a payroll process reviewed now. Schedule a virtual consultation with Strategy Law, LLP today to review your overtime reporting process.

This blog is written as of September 2026. Recommendations and legal requirements are changing rapidly, so please continue to review our legal updates or review postings on relevant government websites.

All blogs on this site are for educational purposes only, do not constitute legal advice or opinion, and should not be applied to your situation, or any specific situation, without consultation with counsel. Strategy Law, LLP does not provide any legal advice concerning any matter discussed in a blog except upon formal engagement including, without limitation, execution of Strategy Law, LLP's formal legal services agreement, and with respect to specific factual situations. No blog constitutes a guaranty, warranty, or prediction regarding the result of any legal matter discussed in the blog or any representation.