The Basics
Managing payroll for a municipality requires navigating a maze of regulations, but few areas are as complex as the compensation of public safety employees. Now, the One Big Beautiful Bill (OBBB) is adding a new layer of complexity.
In 2025, the OBBB created a temporary federal income tax deduction (2025–2028) for the premium portion of FLSA‑required overtime.
This guide summarizes the new compliance requirements into these key focus areas:
- Understanding FLSA Overtime Rules: Public safety employees operate under unique Fair Labor Standards Act (FLSA) Section 7(k) rules, requiring municipalities to adapt payroll systems for alternative work periods and overtime thresholds.
- 2026 W-2 Reporting Mandate: Starting in 2026, municipalities must separately report FLSA-qualified overtime on Form W-2 utilizing new IRS codes to ensure compliance and avoid penalties.
- Action Steps for Compliance: Municipal payroll teams must review systems, configure overtime codes, and train staff to distinguish between FLSA and contract-based overtime, ensuring accurate reporting and tax benefits for employees.
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How OBBB Impacts Understanding Overtime Rules for Public Safety Employees
In 2025, the OBBB introduced significant changes regarding the taxation of overtime by creating a deduction for FLSA-required overtime premiums. The IRS offered penalty relief for noncompliance for the 2025 tax year; however, that grace period has ended.
Starting in 2026, employers must separately report qualified overtime compensation on W-2 forms for all non-exempt employees who are eligible for overtime under FLSA.
Because public safety employees operate under unique overtime rules established by the FLSA, public sector finance departments and payroll teams must understand and adapt to these changes, paying special attention to the differences in overtime calculations between public safety and other employees.
Here’s what you need to know to help your team avoid compliance pitfalls and ensure your public safety teams receive the tax benefits they are eligible for.
FLSA Section 7(k) and Its Impact on Public Safety Overtime
Under the FLSA, city maintenance staff, for example, typically earn overtime after 40 hours worked in a week, but public safety employees such as police and fire personnel often operate under FLSA Section 7(k).
Section 7(k) allows public agencies to establish alternative work periods ranging from 7 to 28 days. This accommodates the unique shift schedules of emergency responders. For example, in a 28-day work period, overtime for fire personnel applies only after the employee works 212 hours. Likewise, overtime for police during a 28-day cycle applies only after 171 hours.
(Click here for the Department of Labor’s guidance in applying FLSA to law enforcement and fire protection personnel, including a link to what constitutes compensable time.)
This flexibility is essential for operations, but it creates payroll complexity. Overtime eligibility is strictly tied to whether employees are FLSA-covered and nonexempt. If a payroll system is hard-coded for a standard weekly setup, it may fail to accurately track the specific “hours worked” thresholds required by Section 7(k).
Overtime Taxability and the “No Tax on Overtime” Deduction
The OBBB introduced a specific tax deduction for the premium portion of overtime pay (the “half” in “time-and-a-half”). This deduction is in effect until 2028 and effectively lowers taxable income for eligible employees. However, it does not apply to all overtime pay.
Determining what counts toward the “hours worked” thresholds can be complicated.
Under FLSA rules, “hours worked” generally excludes paid time off, such as sick leave or vacation. However, collective bargaining agreements (CBAs) may include language that allows counting leave time toward overtime thresholds. This distinction — between what federal law requires and what a contract provides — is central to understanding the new tax updates.
Qualified Overtime
The deduction applies strictly to the overtime required under FLSA. It does not apply to “extra” overtime allowed by state law or CBAs.
For payroll teams, this means your system must distinguish between FLSA overtime and contract-based, or non-FLSA overtime. Lumping all “OT” codes together will no longer suffice. Accurate recordkeeping is essential.
Eligibility and Income Caps
To qualify, employees must be FLSA-covered and nonexempt. High-income earners face limitations. The deduction begins to phase out for single filers with a modified adjusted gross income (MAGI) over $150,000 and joint filers over $300,000. The IRS has updated Form W‑4 for 2026 to include new entries for various deductions, including qualified overtime. This should be communicated to employees to allow them to more accurately adjust their federal withholding and avoid under- or overwithholding as these new deductions take effect.
Impact on Compensatory Time
The FLSA allows public sector employers to satisfy overtime pay requirements with compensatory time off (comp time). Mirroring the FLSA’s time-and-one-half rule, compensatory time must be credited at a rate of 1.5 hours for each overtime hour worked.
For employees covered under the Section 7(k), FLSA overtime is not triggered until hours worked exceed the specific statutory threshold for their designated work period (e.g., 171 hours for a 28-day cycle for police). As such, comp time provided in lieu of FLSA overtime must be calculated based on hours worked specifically beyond these established thresholds.
It’s important to recognize that:
- There are many different types of comp time, such as the contractual comp time provided by a collective bargaining agreement or policy, which do not do not necessarily meet the FLSA’s definition of overtime (e.g., working on a holiday or a “6th day” when the weekly threshold hasn’t been hit).
- Only hours that qualify as FLSA overtime are subject to “time-and-one-half” calculation requirements.
- FLSA comp time should be included in the overtime deduction during the same tax year in which it appears as taxable compensation on the employee’s W-2. This means that any eligible overtime premium associated with a comp time payout would be considered in the year the wages are reported.
Preparing for the New 2026 Form W-2 Requirements
Another critical action item for municipal payroll teams is preparing for the new 2026 W-2 reporting requirements.
Starting with the 2026 tax year, payroll staff must separately report qualified overtime compensation on Form W-2. A new form field has been added to capture this data: Box 12, Code TT, total amount of qualified overtime compensation. Failure to accurately report qualified overtime compensation could result in penalties for the municipality and tax filing challenges for affected employees.
Current Action Steps for Municipal Payroll Teams
Do not wait until December 2026 to address this. If your system is not currently tagging FLSA overtime separately from other premium pay, you will have no way to generate an accurate W-2 at year-end.
Immediate steps include:
1. Conduct a Compliance Checkup
Verify your payroll software can handle multiple overtime codes that feed into different W-2 boxes and configure the system to segregate FLSA 7(k) overtime from daily or double-time overtime mandated only by contract.
Check: Are you correctly applying Section 7(k) periods? Are you including all required stipends in the regular rate? Identify gaps between your current tracking methods and the 2026 reporting requirements.
2. Improve Documentation
Update internal policies to clearly define FLSA overtime versus non-FLSA overtime. Ensure your onboarding packets and annual notices explain the 2026 W-2 changes. Clear communication helps employees understand why their W-2 looks different and why certain overtime hours may not be deductible.
3. Develop Internal Readiness
Create an implementation roadmap. This should include software updates, training for payroll staff on the new coding requirements, and collaboration between HR, finance, and legal teams.
Because limiting employee confusion is just as important as getting the calculations right, consider sharing basic information about the changes with your employees. (Tip: The Government Finance Officers Association (GFOA) offers a downloadable PDF listing commonly asked questions and answers here.)
4. Engage Resources
Stay updated on guidance from the GFOA and IRS. These regulations are evolving, and interpretation can be difficult. When in doubt, consult with advisors who specialize in public sector compensation.
5. Testing
Run simulations to ensure the regular rate of pay is calculated correctly, including nondiscretionary bonuses, to avoid underpaying the FLSA rate.
Your Takeaway
Municipal payroll teams face increasing complexity in overtime calculation, taxability, and reporting. The “No Tax on Overtime” deduction offers a benefit to your public safety employees, but it places a burden of proof and reporting on the employer.
With the 2026 W-2 changes on the horizon and penalty relief ending, now is the time to prepare your systems and policies. Proactive compliance prevents costly errors and builds trust with the public servants who rely on you for accurate compensation.
Navigating the intersection of the OBBB and FLSA is a heavy lift for any municipality. If you have questions about these changes or how they may impact your operations, our team is here to help. Reach out to your Rehmann advisor for tailored advice or click here to connect to one of our Public Sector specialists. We can also assist you with:
- Reviews of FLSA classifications
- Evaluations for payroll setup
- Assessments for overtime tracking
- Payroll provider coordination
- Workforce planning strategy support
- Internal communication planning
- Training for managers and HR
FAQs
Q. What is the “No Tax on Overtime” deduction?
A. It’s a temporary tax deduction (until 2028) for the premium portion of FLSA-required overtime pay, reducing taxable income for eligible employees.
Q. How does FLSA Section 7(k) affect public safety employees?
A. Section 7(k) allows alternative work periods (7-28 days) for public safety employees, with specific overtime thresholds differing from standard 40-hour workweeks.
Q. What steps should payroll teams take to prepare for 2026?
A. Teams should verify payroll systems can track FLSA overtime separately, configure codes for accurate reporting, and train staff on the new IRS requirements.