What should employers change in payroll systems for W-2 reporting of overtime and tips in 2026?
Executive summary
Employers must update payroll systems to capture and separately report qualified overtime and tip amounts beginning with tax year 2026, because the IRS finalized W‑2 changes (new Box 12 codes TT and TP and new Box 14b occupation codes) to implement the One Big Beautiful Bill Act (OBBBA) reporting requirements [1] [2]. There is transition relief for 2025—employers aren’t required to break out these amounts on W‑2s this year but must still provide employees a statement showing potentially deductible overtime or tips, so systems should be readied now even if enforcement is delayed [3] [4] [5].
1. What the law and the forms actually change
Congress created temporary deductions for qualified overtime and qualified tips in the OBBBA and the IRS responded by adding new machine‑readable fields to the Form W‑2: Box 12 codes TT for qualified overtime and TP for cash tips reported to the employer, plus instructions to use Box 14b for up to two Treasury tipped‑occupation codes to determine tip eligibility [1] [2] [6]. The IRS also signaled that Forms 1099‑NEC, 1099‑MISC and 1099‑K will be updated to reflect overtime and tip reporting in coming years, so the change extends beyond payroll wages alone [7] [3].
2. The single most important payroll change: capture the right data now
Payroll systems must begin reliably tracking three discrete data elements per pay period and employee: the qualified overtime “premium” (the half‑time portion of time‑and‑a‑half), total cash tips reported to the employer that may qualify, and the employee’s tipped occupation code to establish eligibility—these are the inputs the IRS expects to appear in the 2026 W‑2 fields [6] [4] [2]. Employers should enable data flags that separate qualified overtime premium from regular wages at the time of computation and ensure tip reporting flows from front‑end POS or tip‑capture processes into payroll exports [6] [3].
3. Calculation rules and edge cases payroll must respect
Only the overtime premium—the extra 0.5× of the regular rate—is deductible and reportable as “qualified overtime,” so systems that now lump full overtime with regular pay must be retooled to isolate that premium [6] [7]. The regular rate itself can be affected by non‑discretionary bonuses and certain inclusions, so payroll must compute regular rates per FLSA guidance before deriving the deductible premium [6]. For tips, employers should follow IRS Notice 2025‑69 and the Treasury’s list of tipped occupations to determine which cash tips qualify and which employees are eligible to deduct them [4] [8].
4. Near‑term relief, employee communications, and recordkeeping
For the 2025 tax year the IRS provides transition relief: employers aren’t penalized for failing to separately report qualified overtime or tips on W‑2s as long as other reporting is accurate, but employers must still give employees a statement or use another “reasonable method” to disclose amounts that may qualify for deduction [3] [9] [10]. Employers should use 2025 as a dress rehearsal—export test files, communicate how employees will see the new codes (Box 12 TT/TP and Box 14b occupation codes), and retain supporting records in case employees or auditors later question eligibility [5] [9].
5. Compliance risk, penalties, and who’s pushing what
The IRS has warned that failure to comply in 2026 and beyond could result in penalties roughly in the $60–$680 range per incomplete W‑2, so the transition relief ends and operational lapses will carry real cost if not fixed [8]. Payroll vendors, law firms and CPA shops are incentivized to position paid upgrade services and compliance packages now, creating a market pressure for employers to buy vendor help even though some smaller employers could implement reasonable internal methods [11] [10]. That market dynamic is an implicit agenda to watch when evaluating vendor proposals.
6. Practical implementation roadmap for 2026 readiness
Immediate steps are: map system fields to new W‑2 codes (TT/TP, Box 14b occupation codes), update timekeeping rules to compute and tag the overtime premium, ensure tip capture flows into payroll, run end‑to‑end tests that produce mock W‑2 exports, and update employee communications and privacy controls for any online statements; engage payroll vendors and tax counsel for validation before year‑end 2026 [6] [3] [11] [9]. If systems cannot be changed quickly, document a defensible “reasonable method” for 2025 and set firm project timelines to remove that workaround before mandatory 2026 reporting begins [5] [10].