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.
In2025,theOBBB created a temporary federal income tax deduction (2025–2028) for the premiumportionof FLSA‑required overtime.
This guidesummarizesthe new compliancerequirementsintothesekeyfocusareas:
- Understanding FLSA Overtime Rules:Public safety employeesoperateunder uniqueFair 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-2utilizingnew 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, ensuringaccuratereporting and tax benefits for employees.
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HowOBBBImpactsUnderstanding Overtime Rules for Public Safety Employees
In 2025, theOBBB introduced significant changesregardingthe taxation of overtimebycreating a deduction for FLSA-required overtime premiums.TheIRS offered penalty relief fornoncompliance forthe 2025 taxyear;however,that grace periodhas ended.
Starting in 2026, employers must separately report qualified overtime compensation on W-2formsfor all non-exempt employees who are eligible for overtime underFLSA.
Becausepublic safety employeesoperateunder unique overtime rulesestablishedby theFLSA,public sector financedepartmentsand payroll teamsmust understand and adapt to these changes,paying special attention to thedifferencesin overtime calculationsbetween public safety and other employees.
Here’s what you need to know to help your teamavoidcompliancepitfallsandensureyour public safety teams receive the tax benefits they areeligible for.
FLSA Section7(k)and Its Impact onPublic Safety Overtime
Under the FLSA,city maintenancestaff, for example,typically earn overtime after40 hoursworkedin a week,butpublic safety employees such aspolice and fire personnel oftenoperateunder FLSA Section 7(k).
Section 7(k) allows public agencies toestablishalternative work periods ranging from7to28 days. This accommodates the unique shift schedules of emergency responders. For example,in a28-daywork period,overtimefor fire personnelapplies onlyafterthe employee works212 hours.Likewise,overtime for policeduring a 28-day cycleappliesonlyafter171 hours.
(Clickfor the Department of Labor’s guidance in applying FLSA to law enforcement and fire protection personnel, including ato what constitutes compensabletime.)
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 ishard-codedfor a standard weekly setup, it mayfail toaccurately 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.
Determiningwhat counts toward the “hours worked” thresholdscan be complicated.
UnderFLSArules, “hours worked”generally excludespaid time off, such as sick leave or vacation. However, collective bargaining agreements (CBAs) may include languagethatallowscounting leave time toward overtime thresholds. This distinction — between what federal lawrequiresand what a contractprovides— iscentral tounderstanding the new tax updates.
QualifiedOvertime
The deduction applies strictly tothe overtimerequired under FLSA.It does not apply to “extra” overtimeallowedby state law orCBAs.
For payroll teams, this means your system must distinguish between FLSAovertime and contract-based, ornon-FLSAovertime. 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-incomeearners face limitations. The deduction begins to phase out for singlefilerswith amodifiedadjusted 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-oroverwithholdingas these new deductions take effect.
Impact on Compensatory Time
The FLSAallowspublic sectoremployers to satisfyovertime pay requirements withcompensatory timeoff(comp time).Mirroringthe FLSA’s time-and-one-halfrule, compensatory time must be credited at a rate of 1.5 hours for each overtime hour worked.
For employees covered under theSection 7(k),FLSA overtime is not triggered until hours worked exceed the specific statutory threshold for their designated work period (e.g.,171 hoursfor 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 recognizethat:
- 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 asFLSA overtime are subject to“time-and-one-half” calculation requirements.
- FLSA comp time should be included in the overtime deduction during the same taxyear in which itappears 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 criticalaction item for municipalpayroll teamsis preparing for thenew2026W-2reportingrequirements.
Starting with the 2026 tax year, payroll staff must separately report qualified overtime compensation on Form W-2.A newform fieldhas been added to capture this data:Box 12,Code TT,total amount ofqualified overtime compensation.Failure to accuratelyreport qualified overtime compensationcould result in penalties for the municipality and tax filingchallengesforaffectedemployees.
Current Action Steps forMunicipal Payroll Teams
Do notwait 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 generatean accurateW-2 at year-end.
Immediate steps include:
1. Conduct a Compliance Checkup
Verifyyour payroll software can handle multiple overtime codes that feed into different W-2 boxesand 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?Areyou including all required stipendsinthe regular rate?Identifygaps between your current tracking methods and the 2026 reporting requirements.
2. Improve Documentation
Update internal policies to clearly define FLSAovertime versusnon-FLSA overtime.Ensure your onboarding packets and annual noticesexplainthe 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 animplementationroadmap. This should include software updates,training forpayroll staff on the new coding requirements, and collaboration between HR, finance, and legal teams.
Becauselimiting employee confusion is just as important as getting the calculations right, consider sharingbasic information aboutthechangeswith your employees.(Tip:TheGovernment Finance Officers Association (GFOA) offersadownloadable PDF listing commonly asked questions and answers.)
4. Engage Resources
Stay updated onguidance from the GFOAand 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 changeson the horizonand 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 foraccuratecompensation.
Navigating the intersection ofthe OBBB andFLSA is a heavy lift for anymunicipality.If you have questions about these changes or how they mayimpactyour operations, our team is here to help. Reach out to your èƵ advisor for tailored advice orclickhereto connect to one of our Public Sector specialists.We canalsoassistyou 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.