No Tax on Overtime: What Contractors Must Track for Payroll

The federal no tax on overtime deduction is your employees' tax break, but the paperwork is yours. Starting with tax year 2026, employers have to report each worker's qualified overtime on the W-2. In construction, the number you report is rarely the same as total overtime pay. This guide covers what counts, how to calculate it, and what to set up in payroll now so you aren't rebuilding the year's numbers in January.

What the no tax on overtime deduction actually is

Eligible workers can deduct the part of their overtime pay that is above their regular rate. Under the IRS summary, the most anyone can deduct is $12,500 a year, or $25,000 on a joint return. The deduction starts shrinking once modified adjusted gross income passes $150,000 ($300,000 for joint filers).

It's a deduction on the employee's personal return. It does not reduce what you withhold for Social Security or Medicare, and it doesn't change what overtime you owe. Your job is to report the correct amount so your crew can claim it.

2025 versus 2026

The law passed in mid-2025 but applied to the whole year, so the IRS treated 2025 as a transition year. Notice 2025-62 waived penalties for 2025 for employers who didn't report qualified overtime separately. The IRS still encouraged employers to give workers the figure through Box 14, a separate statement, or an online portal. Workers who got no figure could work out their own amount using the Schedule 1-A instructions.

For 2026 there is no transition relief. According to the IRS's updated Q&A, employers report total qualified overtime on Form W-2 in Box 12 using code TT. That means you need clean overtime data for every pay period of 2026, not only at year-end.

What counts as qualified overtime (and what doesn't)

The IRS defines qualified overtime as overtime that the Fair Labor Standards Act (FLSA) requires, and only the part paid above the regular rate. Most of the mistakes contractors make come from those two limits.

Only the half-time premium counts

If you pay time and a half, the extra "half" is the qualified part. The "time" is ordinary wages. The IRS formula for each workweek is one-half times the employee's FLSA regular rate, times the overtime hours the FLSA requires.

Only FLSA-required hours count

The FLSA requires overtime for hours over 40 in a workweek. Overtime you pay for any other reason doesn't count. That includes your own company policy, a state law, or a union agreement. NATP's review of the IRS FAQs says voluntary, state-law, or contractual overtime that goes beyond the FLSA doesn't qualify. Here's what that means on a jobsite:

• Daily overtime under state law. Suppose a state requires overtime after 8 hours in a day, and a worker has a few long days but stays under 40 for the week. That overtime is real and you have to pay it, but none of it is qualified.
• Double time on Saturdays or holidays. Even when the hours are over 40, only the half-time portion counts. The University of Illinois Tax School gives this example: holiday pay at two times the regular rate qualifies only for the one-half portion.
• Union overtime rules. If a collective bargaining agreement triggers overtime earlier or at a higher rate than the FLSA, only the FLSA-required piece counts.

Exempt employees never qualify

Some project managers, estimators, and office staff are salaried and exempt under the FLSA. If you pay them extra for long weeks, that pay is not qualified overtime. The IRS notice says overtime paid to FLSA-ineligible employees doesn't qualify, regardless of state law. Review your foremen and lead carpenters in particular. Being called "salaried" doesn't make someone exempt, and it's worth confirming how each person is classified before you report.

How to calculate it: three construction examples

These examples use simple numbers. Your payroll provider or CPA should confirm your actual setup.

Example 1: one rate, 50 hours

A carpenter earns $30 an hour and works 50 hours in a week. You pay 40 hours at $30 ($1,200) plus 10 hours at $45 ($450). Qualified overtime is 10 hours times $15 (half of $30), which is $150. The other $300 of overtime pay is ordinary wages.

Example 2: two rates in one week

This one matters most for contractors. Your crew may split a week between a private remodel and a prevailing-wage job, or between laborer work and equipment operation, each with its own rate. Overtime isn't based on whatever rate they were earning during the overtime hours. The Department of Labor describes using a weighted average when someone works two or more jobs at different rates in the same week. Under 29 CFR 778.115, construction is one of the places where people get this wrong.

Say a worker puts in 30 hours at $28 and 20 hours at $40, for 50 hours total. Straight-time earnings are $840 plus $800, or $1,640. The regular rate is $1,640 divided by 50 hours, which is $32.80. Qualified overtime is 10 hours times $16.40, or $164.

You can only do this if you know which hours were worked at which rate. Time that isn't coded to the right job and pay class will throw off both the overtime check and the W-2 figure.

Example 3: a production bonus

Nondiscretionary bonuses go into the regular rate. These are bonuses you promise ahead of time for things like finishing on schedule, attendance, or safety. The DOL's worked example shows a bonus added to straight-time earnings and then divided by total hours. That raises the regular rate, which raises both the overtime premium and the qualified overtime. If you pay crews a completion bonus, your payroll has to fold it into overtime for the weeks it covers.

What to set up in payroll now

The Municipal Research and Services Center advises employers to keep records that separate FLSA-required overtime from other kinds of extra pay. For a small contractor, that comes down to five habits:

1. Confirm who is non-exempt. List every employee and their FLSA status. Pay close attention to salaried foremen and supervisors.
2. Separate overtime pay codes. Track FLSA weekly overtime apart from state daily overtime, policy overtime, and double time. If everything goes into one "OT" bucket, you can't pull the code TT number out later.
3. Record hours by job and by rate. Weighted-average overtime depends on knowing how many hours were worked at each rate. A GPS time clock that codes hours to the job as they're worked gives you that record without anyone rebuilding it from a whiteboard on Friday.
4. Include bonuses in the regular rate. Write down which bonuses are promised and which are discretionary, and make sure the promised ones go into overtime math.
5. Check a pay stub each quarter. Pick one employee who worked multiple rates and overtime, and recalculate a week by hand. If the result doesn't match payroll, fix the setup now, not in January.

If you aren't sure how clean your time data is, run a recent timesheet export through the free labor-cost check. It will show you where hours and rates don't line up.

What about 1099 subs?

The IRS mentions Forms 1099-NEC and 1099-MISC alongside the W-2, but the deduction is still limited to overtime the FLSA requires. True independent subcontractors who bid work and run their own businesses generally aren't owed FLSA overtime at all. The real risk is misclassification. If someone you pay on a 1099 works your hours, uses your tools, and takes direction like an employee, overtime and the new reporting rules could both apply. Ask your CPA or employment attorney about any worker who doesn't clearly fit.

Why this matters beyond the W-2

Your crew will notice the new line on their paperwork. Workers who rely on overtime will compare the code TT figure with what they think they earned. If it's wrong, the questions come to you. And the same data that makes the W-2 number correct also shows you labor cost by job. Overtime that never makes it into your job cost reports is one of the quieter ways margin disappears on long jobs.

Partner's time clock and payroll record hours by job and rate in the same system, so overtime can be calculated from the actual week instead of reconstructed afterward. Whatever tool you use, the rule is the same: get the time data right during the week, and the year-end reporting follows from it.

This article is general information, not tax or legal advice. IRS guidance on qualified overtime has been updated several times, so confirm current rules with your tax professional.