If you run payroll for employees who work overtime, 2026 brings a new requirement you need to act on now.
The Working Families Tax Cut Act — signed into law on July 4, 2025 — created a new tax deduction for qualified overtime compensation. Eligible employees can deduct up to $12,500 of qualified overtime pay from their taxable income for tax years 2025 through 2028. For joint filers, the limit is $25,000.
To support this deduction, the IRS requires that qualified overtime compensation be tracked and reported separately — starting with 2026 W-2 forms. That means your payroll system needs to capture qualified overtime as a distinct line item, separate from regular overtime pay.
This guide walks you through exactly what qualified overtime compensation is, how it works under the FLSA, and the step-by-step process to set up qualified overtime tracking in QuickBooks Desktop.
Qualified overtime compensation is the premium portion of overtime pay that an employer is required to pay under Section 7 of the Fair Labor Standards Act (FLSA).
Here is how it works in plain terms. Under the FLSA, eligible employees must be paid at least 1.5 times their regular hourly rate for every hour worked over 40 in a single workweek. If an employee earns $20 per hour, their overtime rate is $30 per hour. Of that $30, only the extra $10 — the premium above their regular $20 rate — counts as qualified overtime compensation for purposes of the new tax deduction.
The deduction applies only to FLSA-required overtime. Overtime pay required by a state law, a union contract, or a company policy above FLSA minimums does not qualify. This distinction is important when you are calculating which portion of each employee's overtime pay to track separately.
According to IRS guidance, qualified overtime compensation is the amount that exceeds the employee's regular rate of pay and is required under FLSA Section 7. This is exactly the "half" in "time-and-a-half." As covered in the QuickBooks timesheets and overtime management guide, understanding the difference between total overtime pay and the FLSA premium is the foundation of accurate overtime tracking.
The deduction is taken by the employee on their personal income tax return — not by the employer. Your role as the employer is to track and report the qualified overtime compensation accurately so your employees can claim the deduction.
Key rules to know:
Important note: There are no changes to payroll tax withholding. Qualified overtime is still fully subject to federal income tax withholding, Social Security, and Medicare taxes in the paycheck. The deduction is taken at the individual level when the employee files their tax return — not at the payroll stage.
This connects directly to the broader payroll setup process covered in how to run payroll efficiently in QuickBooks Desktop — where accurate payroll item setup is the foundation of clean, compliant payroll processing.
QuickBooks Desktop can track standard overtime pay automatically using its built-in payroll items — Overtime Rate (1.5x) and Double Time Rate (2x). However, QuickBooks Desktop cannot automatically calculate the qualified portion of overtime pay.
You need to manually calculate the qualified overtime amount — the FLSA-required premium only — and enter it as a separate tracking item in each paycheck. QuickBooks then records that amount and includes it in your payroll reports so it is available when you prepare W-2 forms.
This manual calculation step is a key part of the process. The setup is straightforward once you understand what you are tracking and why.
Before you set up any new payroll items, make sure QuickBooks Desktop is fully updated.
Update QuickBooks Desktop:
Update your Payroll Tax Table:
Keeping your tax table current ensures QuickBooks has the latest payroll rules and any available updates related to qualified overtime tracking. Learn more about QuickBooks Enhanced Payroll for Desktop and how your payroll subscription tier affects the tools available to you.
After updating QuickBooks, check whether a Qualified Overtime Tracking item was added automatically to your Payroll Item List. If it was, you can skip directly to Step 3.
If it was not added automatically, create it manually:
Note: Some versions of QuickBooks Desktop Premier and Enterprise may not show an "Other Earnings" option under Wage types. If this is the case in your version, select the closest available wage type and name the item clearly as Qualified Overtime Tracking. Check the QuickBooks Community for version-specific guidance if needed.
Once the payroll item exists, assign it to every employee who is covered by the FLSA and regularly works overtime.
Repeat this for every eligible employee. For a full overview of how payroll items connect to employee records in QuickBooks Desktop, see how to adjust payroll liabilities in QuickBooks Desktop — accurate item assignment is essential for clean payroll records.
This is the manual step. For each pay period, calculate the qualified overtime amount for each eligible employee before running payroll.
The formula:
Qualified Overtime Amount = (Regular Hourly Rate ÷ 2) × Qualified Overtime Hours
Why divide by 2? Because the qualified portion is only the premium — the "half" of "time-and-a-half." If an employee earns $20/hour and works 8 overtime hours:
That $80 is the qualified overtime compensation to enter as the tracking item amount.
Important: Only FLSA-required overtime hours count. Hours beyond FLSA requirements due to company policy or state law do not qualify. Track FLSA overtime hours separately from any additional overtime your company pays.
When you process each paycheck, enter the calculated qualified overtime amount manually:
The Qualified Overtime Tracking item records the amount separately from the employee's regular overtime pay. This gives you a clean, separate record that feeds into your payroll reports and supports W-2 preparation at year end. For more on how time entry flows into QuickBooks Desktop payroll, see how to clock in hours in QuickBooks Desktop.
Run the Payroll Summary report regularly to monitor qualified overtime amounts by employee and verify that your tracking is accurate throughout the year.
Keep this report on file and update it after each payroll run. At year end, these totals feed into your W-2 preparation. Starting with 2026 W-2 forms, qualified overtime compensation is expected to be reported in a designated box — so accurate, organized records throughout the year make year-end reporting straightforward.
For a complete year-end payroll close process, see the accounting year-end checklist — where payroll reconciliation and W-2 preparation are core steps before closing the books.
Payroll work in QuickBooks Desktop often involves multiple people — bookkeepers, accountants, HR staff, and business owners. When more than one person needs to access the same QuickBooks company file to process payroll, track overtime, and review records, coordination becomes essential.
Qbox is accounting collaboration software built for QuickBooks Desktop users. It makes multi-user payroll workflows smooth, secure, and conflict-free.
Setting up qualified overtime tracking in QuickBooks Desktop is a straightforward process once you understand what you are tracking and why. The key steps are:
The most important thing to remember: only the premium portion of FLSA-required overtime qualifies. Calculate it correctly each pay period, keep your records organized, and your 2026 W-2 reporting will be clean and compliant when year end arrives.