Employer and Employee Alert: Certain overtime compensation may now be excluded from certain employee’s taxable income, reported as tax deductions on their individual tax returns. This financial benefit results from the federal One Big Beautiful Bill Act (“Act”), amending Section 225 of the Internal Revenue Code. Significant caveats apply, however, to which employees may claim such tax deductions. This legal development heightens significant employer compliance aspects as explained in the following sections, such as properly classifying exempt and non-exempt employees, determining whether workers are employees or independent contractors, handling overtime calculations, keeping accurate records of time worked by non-exempt employees, and paying the correctly determined amounts owed to them.
New Legislation – Tax Deduction for Certain Overtime Pay
A nonexempt employee is legally entitled to overtime pay for hours worked over 40 in a work week, at 1½ times the employee’s regular rate of pay. Applying this basic legal framework to the new employee tax deduction, its specific applicability is quite constrained as follows:
1. Eligible overtime pay applies only for wages earned in tax years 2025, 2026, 2027, and 2028.
2. The law applies to federal income taxes, as well as many state income taxes – but not all states. Illinois, Colorado, and New York have opted to continue taxing all overtime income, and thus employees in those states will need to deduct eligible overtime compensation only from federal income tax.
3. The benefit is available only to non-exempt employees, as further addressed below, up to a maximum annual tax deduction of $12,500 for single filers and $25,000 for married couples filing jointly. Additionally, it phases out for taxpayers with a modified adjusted gross income over $150,000 for single filers and $300,000 for joint filers.
4. Eligible employees may claim only a portion of their overtime compensation that is over their regular pay – i.e., the “half” of the “time-and-a-half” compensation earned by such employees.
5. This tax benefit is only for income tax liability. It does not apply to Social Security or Medicare benefits.
6. As a further limitation, this tax benefit applies only to overtime compensation that is required under the Fair Labor Standards Act. For example, double pay for holidays worked may not be included in an eligible employee’s overtime tax deduction since it is not legally required. Similarly, any compensation premium paid to a non-exempt employee who works more than eight hours in a single day will not qualify, if such employee does not work more than forty hours total that week.
Overtime Employer Compliance and Best Practices
Employers should not experience significant implications from the new legislation itself. Instead, this new law provides a potent reminder that overtime legal compliance involves significant definitional and accompanying parameters warranting careful attention, especially for nonprofit organizations. The following key employment areas should thus be reviewed and addressed further as may be needed, based on each employer’s evaluation.
Worker Classification
As a key initial step, make sure that all workers are properly classified – as employees, independent contractors, or volunteers. Only employees are entitled to overtime pay and, of that subset, only certain non-exempt employees (as addressed further below).
Correctly distinguishing between a nonprofit’s employees and independent contractors can be tricky. For example, if the worker is well integrated into a nonprofit’s operations and carries out many types of activities on a relatively long-term basis, then the worker is likely best classified as an employee. Note too that employee classification under state law depends on the worker's location, which in turn may raise a host of legal compliance issues for nonprofits with multi-state operations or remote workers. Additionally, there is no such thing – legally speaking – as an employee who receives an IRS Form 1099. Such tax form is only for independent contractors; employees receive IRS Form W-2. The Internal Revenue Code also mandates that every corporate officer generally be classified as an employee, regardless of how much time the worker spends on nonprofit business or the nature of the worker’s specifics, as a bright-line approach presumably based on governing boards’ direct control of corporate officers. Related guidance is provided through our law firm’s Employee vs. Independent Contractors article.
Within the nonprofit employer context, it is possible that workers may be volunteers instead – without any entitlement to overtime pay (or any pay at all). Unfortunately, the Fair Labor Standards Act (FLSA), under which overtime pay may be owed by an employer, does not clearly define the word "employee.” Instead, the FLSA provides simply that an “employee” as “any individual employed by an employer," and "employ" means “to suffer or permit to work." Some court decisions have tried to add substance to these definitions, typically requiring some expectation of remuneration or at least that the "economic realities" of the situation suggest that the worker is economically dependent on the position. This issue is addressed in further detail through our firm’s guest article by Joseph Mead.
As a further subset of volunteers, a worker could be an unpaid intern. Such classification can likewise be tricky, such as if the intern receives a “stipend” or other economic benefit. Under applicable legal requirements, any paid intern is an employee (and therefore entitled to both minimum wage and overtime pay) if the person is not the “primary beneficiary” of the internship. How to evaluate such requirement is addressed in our law firm’s article on Nonprofits and Interns.
Exempt vs. Non-Exempt Employees
Who is an exempt employee, and who is non-exempt? A worthwhile resource that addresses that question for nonprofit employers (and much more!) is the Evangelical Council for Financial Accountability (ECFA)’s e-book on “Answering Your Overtime Questions.” This resource is accessible through our firm’s website. As explained in this e-book, an “exempt” employee is not subject to the FLSA’s employee protection requirements and thus will not be entitled to overtime pay (or minimum hourly wages).
An employee could be exempt under the well-known “white-collar exemption,” by satisfying all three elements of the following FLSA test for executive, administrative, and professional employees: (a) their job activities must fit within the FLSA’s description of “executive, administrative, or professional” (such as the exercise of independent judgment over significant work matters, supervisory responsibilities, or the performance of work required advanced knowledge); (b) they are paid on a salary basis; and (c) they meet the FLSA’s salary threshold. Significant legal attention has been given to the salary threshold requirement, as addressed in our law firm’s November 2024 blog article.
Additionally, ministers are categorically exempt from FLSA coverage so long as they are properly defined for such legal purposes as “ministers.” The ministerial exemption is a legal principle grounded in federal court decisions recognizing that ministers may not bring discrimination claims against their employers, primarily due to First Amendment considerations and the related goal of avoiding government involvement in religious issues. No one factor is determinative for ministerial status, but the person’s job duties, title, and related training should all have a heavy religious emphasis for the ministerial exemption to apply. Notably too, the employer does not need to be a church; it may be a school, a campus ministry, or other faith-based organization. Such legal considerations regarding wage issues and other religious liberty protections are covered in our law firm’s Ministerial Exemptions article.
Notably as well, teachers are categorically exempt from the FLSA. To satisfy this exclusion, these employees’ primary duty must be to teach, and they must be engaged in this activity in an educational establishment. A “seasonal operations” exemption may apply as well, depending on the specific facts such as time periods of operations and financial aspects. Other categorical exemptions may apply as well, depending on specific work responsibilities.
Figuring Out Overtime Pay Obligations
What should employers do with respect to non-exempt employees who may be owed overtime pay (regardless of whether they can claim this new tax deduction or not)? Several pointers are listed in our law firm’s November 2016 article co-authored with Mike Batts, CPA of Batts Morrison Wales & Lee, particularly if an employee is salaried but still non-exempt. Notably, the salary threshold and related dollar amount portions listed in this article have been superseded by later legal developments affecting the applicable salary threshold amount for the white-collar exemption, as addressed in our firm’s The applicable salary threshold amount for this exemption is $35,568, which is $684 per week. Note too that other exemptions do not include a salary threshold, such as for qualified ministers and teachers.
These pointers include the following recommendations for how employers can best handle overtime pay determinations and calculations:
· Per above, evaluate employee qualification for the white-collar, ministerial, and other potentially available exemptions, which may completely avoid overtime pay issues.
· Address non-exempt vs. exempt employee status in employee handbooks, job descriptions, offer letters, and other employer communications, as well as related work expectations and employee rights, for optimal clarity.
· For non-exempt employees who are or will be working overtime pay, make sure to require accurate record-keeping by employees – with accompanying payroll software or other effective systems for such vitally important employment records. Record-keeping practices may be otherwise helpful as well, such as occasional overtime worked by non-exempt employee and overall accountability.
· For tax year 2025, include overtime pay that is eligible for the new tax deduction in employees IRS Form W-2, in its Box 14 (“Other”; and pending further IRS developments for updated Form W-2 in subsequent tax years).
· Consider whether to prohibit non-exempt employees from working more than 40 hours per week, to avoid overtime pay issues and accompanying record-keeping. This approach assumes that such prohibition can be enforced, which may or may not be realistic. Note too that an employer will still owe overtime pay for any overtime work, but such issue may be addressed as an employee disciplinary matter.
· For salaried employees who are non-exempt, consider converting their compensation to hourly rates. This may or may not be an attractive option, however, since some employees prefer to earn salaries rather than to be paid at an hourly rate and since such employees must then record all hours worked. It could be less attractive financially too from the employer’s perspective, depending on the amount of overtime work involved.
· From an overall budgeting perspective, consider determining the total compensation desired for a specific non-exempt job position and then factor in any expected overtime pay as part of the regular compensation amount.
· For non-exempt positions with current or expected overtime work requirements, consider too whether to reallocate job responsibilities to avoid any overtime work and pay. Correspondingly, evaluate the related implications for employee availability and interest in working overtime.
· Last, consider whether and to what extent to offer flexible hours worked within a week to non-exempt employees. They would not be eligible for “comp” time – that is, time off one week based on extra hours worked a different week, as may be allowed for exempt employees who receive the same salary regardless of total hours worked. For example, an employee who wants to take off an afternoon for Christmas shopping (or other worthwhile personal endeavors) could work longer hours the next day, but not exceeding 40 hours total for the work week. Under this scenario, the employer would not owe any overtime pay and eligible employees may appreciate this practical benefit.
Nonprofit employers may vary widely in whether they have employees or other types of workers, whether all or some of their employees are non-exempt, and the expected and necessary employee hours worked (particularly for occasional conferences or other special events). All such considerations lead to the key question of whether overtime pay is owed. If so, their employees may very well benefit from this new tax deduction for the “half” premium portion over the regular “time” compensation amount. That is good news and may be communicated accordingly by employers. As helpful with employment matters, such updates should be communicated timely and clearly, through employee handbooks or other policy change notices.
