No Tax on Overtime: What Cities Must Do from a Payroll

Recent federal legislation creating a tax deduction for qualified overtime pay has generated significant questions from cities, particularly around payroll obligations, withholding, and how overtime must be tracked. Much of the confusion stems from the assumption that overtime is now “tax-free” at the payroll level. That is not the case.

This post outlines what cities are required to do and, just as importantly, what they are not required to do.

There Is No Immediate Change to Payroll Withholding

From an employer standpoint, the most important point is this: cities continue to withhold federal income tax on overtime wages just as they always have, unless and until the IRS issues future withholding guidance. The law creates an above-the-line deduction for employees when they file their individual tax returns, but it does not automatically exempt overtime wages from withholding at the time payroll is run.

For cities, this means that federal income tax withholding remains unchanged for both regular wages and overtime wages. FICA taxes, including Social Security and Medicare, continue to apply to overtime compensation, and state and local income taxes also remain in place unless state law changes independently. Importantly, employer payroll tax costs do not decrease as a result of this change. At least for the current transition period, any tax benefit is realized by the employee at filing, not through increased net pay during the year.

Cities Must Be Able to Identify Overtime Pay, But Not Redesign Payroll Overnight

Although withholding does not change immediately, the ability to identify overtime pay separately does matter for reporting purposes. Cities should ensure their payroll systems can distinguish regular hours from overtime hours under the FLSA or any applicable exemption, identify the overtime premium portion of pay, and generate year-end totals of qualified overtime compensation if required for W-2 reporting.

For the initial transition year, the IRS has indicated that employers may rely on reasonable methods to identify overtime compensation. Cities are not required to retroactively rebuild payroll systems or reclassify historical payroll data with perfect precision. Looking ahead, cities should expect the IRS to require separate reporting of qualified overtime compensation on Form W-2 beginning in a future tax year. This is expected to occur through the addition of a new box or code, rather than an entirely new W-2 form, with payroll vendors handling the technical changes.

State Law vs. Federal Tax Treatment

It is important to distinguish between how cities calculate and pay overtime under Kentucky law and how overtime is treated for the federal tax deduction. For example, Kentucky cities may pay police overtime on an 80-hour, two-week basis pursuant to KRS 337.285(13)(a), and cities may pay firefighters according to local policies rather than a §207(k) schedule. These pay practices remain lawful and should not be changed. However, for purposes of the federal “no tax on overtime” deduction, only the hours actually paid as overtime are potentially eligible. The deduction does not require cities to retroactively treat additional hours as overtime, nor does it override state-law thresholds or local pay rules. Payroll reporting and employee benefits are tied strictly to overtime compensation that is actually paid.

IRS Guidance and Penalties

The IRS has confirmed that employers and other payors are not subject to penalties for failing to separately report qualified overtime compensation for the 2025 tax year. According to the IRS, Treasury and IRS are aware that many employers may not yet have the information, systems, or procedures necessary to accurately report these amounts under the “one big beautiful bill.” Employers who are able to provide employees with separate accounting of overtime compensation are encouraged to do so, but it is not required for 2025. This guidance ensures that cities can continue their current pay and payroll practices without concern for penalties while preparing for future reporting requirements.

Leave Time Does Not Count as Overtime for This Purpose

A common question from cities concerns whether paid leave counts as overtime for purposes of the deduction. It does not. The deduction is tied to actual hours worked, not paid time off. Holiday pay, sick leave, vacation leave, and other paid leave do not qualify, even when paid at a premium rate. Similarly, compensatory time payouts do not qualify unless they are directly tied to overtime hours actually worked.

From a payroll perspective, cities must continue to track leave categories separately from hours worked. Payroll systems that already distinguish between regular hours, overtime hours, and various leave types are generally sufficient. Cities should avoid recharacterizing leave as overtime to increase employee eligibility, as doing so could create compliance risks under both federal tax law and wage-and-hour rules.

Fire Departments and 24/48 Schedules Require Special Attention

Fire departments present unique issues due to scheduled overtime and the use of FLSA §207(k) work periods. Scheduled overtime that is inherent in a 24/48 or similar schedule does not automatically disqualify hours from being considered qualified overtime. Instead, overtime is determined by whether hours worked exceed the applicable FLSA threshold for the established work period.

Payroll systems must correctly identify which hours exceed the FLSA threshold, rather than relying solely on how hours are labeled in a schedule or pay code. For example, if a firefighter exceeds the §207(k) threshold during the work period, those excess hours may qualify. Conversely, hours paid at a premium rate that do not exceed the FLSA threshold may not qualify as overtime for tax purposes. Cities should coordinate closely with payroll and fire department leadership to ensure that overtime calculations are accurate, consistent, and defensible.

What Cities Should Be Doing Now

From a practical standpoint, cities should focus on preparation rather than drastic changes. This includes confirming that payroll systems can properly separate regular hours, overtime hours, and leave categories; coordinating with payroll vendors on anticipated W-2 reporting changes; and training payroll and HR staff to explain that the deduction is not a payroll-level tax exemption. Cities should also avoid changing withholding practices unless and until the IRS explicitly requires it and should ensure that fire department overtime calculations remain fully FLSA-compliant.

Bottom Line for Cities

The “no tax on overtime” change is primarily an employee tax filing issue, not an immediate payroll overhaul for cities. Cities are not expected to eliminate withholding on overtime or redesign payroll systems overnight. The city’s core obligations remain accurate timekeeping, correct FLSA overtime calculations, and readiness to report overtime separately when required. Leave time remains outside the scope of the deduction, and scheduled overtime must still be evaluated under existing wage-and-hour rules. As additional IRS guidance is released, cities should expect clarification rather than disruption.