Mulling Worker Reclassification In Light Of No Tax On OT
Enacted on July 4, the One Big Beautiful Bill Act, or H.R. 1, includes a provision for "no tax on overtime."[1] As a result, salaried employees who work long hours but do not receive overtime compensation could benefit from a change in their Fair Labor Standards Act status.
Whether salaried employees are reclassified as nonexempt is a decision that employers will make. Some employers that determine that there are substantial tax benefits from the change in the tax code for certain of their exempt employees are expected to reclassify these employees as nonexempt from the FLSA and begin paying overtime compensation to increase their after-tax earnings.
The change in FLSA status caused by the change in the tax code may occur for millions of workers.
The 2024 Current Population Survey, or CPS, reports that over 20 million workers usually work more than 40 hours per week, but most of these workers are either salaried employees or independent contractors who are self-employed, not hourly employees.[2]
Among individuals who typically work more than 40 hours per week, the new law generates a tax advantage only to nonexempt employees whose overtime compensation will have more favorable tax treatment.
The change in the tax code may lead to more misclassification lawsuits in the short run, as some exempt employees and independent contractors recognize that there is now a greater benefit to a change in their FLSA status.
In addition, employers that change the FLSA status of their exempt employees so that overtime compensation is not taxed will likely encounter higher compliance costs and future wage and hour lawsuits.
The New Tax Treatment of Overtime Compensation
While some changes in the new tax legislation are permanent, the no-tax-on-overtime provisions take effect for the entire 2025 tax year, but are set to expire after the 2028 tax year.
The law states that "an amount equal to the qualified overtime compensation received during the taxable year and included on statements furnished to the individual" will be allowed as a deduction for personal income taxes.[3] The term "qualified overtime compensation" refers to overtime compensation that is required by the FLSA.
The overtime deduction equals the premium paid for overtime compensation required by the FLSA, which is one-half the worker's regular rate of pay multiplied by the number of overtime hours worked.[4]
Further, the overtime deduction is limited to $12,500 per year for an individual, and $25,000 for a joint return. It will begin to be phased out for individuals with annual taxable income exceeding $150,000, and $300,000 for a joint return. CPS Data on Workers With Long Workweeks
There is potential for many workers to be reclassified, because only 34.5% of employees and 28.7% of workers, including independent contractors and those who are self-employed, in the private sector who typically work more than 40 hours per week are hourly employees, according to the 2024 CPS.
The CPS also shows that in the private sector:
- 8.8% of hourly employees usually work more than 40 hours per week, and they work an average of 51 hours per week;
- 22.4% of nonhourly employees usually work more than 40 hours per week, and they work an average of 52 hours per week; and
- 24% of self-employed workers, including independent contractors, usually work more than 40 hours per week, and they work an average of 56.1 hours per week.
Some occupations, including first-line supervisor positions, include large numbers of both salaried and hourly employees depending on the employer, location and industry of the job.
Exempt employees in these occupations may be the most likely to be reclassified as nonexempt to take advantage of tax-free overtime pay because many employees in these jobs already receive overtime compensation.
Example: First-Line Supervisors of Retail Trade Workers
As an example, consider retail supervisors.[5] These employees supervise cashiers, sales associates and other nonexempt workers in retail establishments.
According to the 2024 CPS, there are more than 2 million retail supervisors in the U.S. Of these employees, 51.7% are paid by the hour, while 48.3% are nonhourly employees.[6] In addition, 43.9% of nonhourly retail supervisors indicated that they usually work more than 40 hours per week.
The 2024 CPS also reported that the median weekly compensation of nonhourly retail supervisors, who usually work more than 40 hours per week, was $1,500 for a typical 50- hour workweek last year.
This could result from a $1,500 salary per week, or an hourly base wage of $27.27 and an overtime wage of $40.91, at 1.5 times the base wage, for 10 hours of weekly overtime.
If overtime hours are stable and predictable, the hypothetical median retail supervisor who earns a $1,500 salary for a standard 50-hour week, if reclassified to nonexempt, would likely earn a regular rate of $27.27, according to economic reasoning.
In other words, basic economic reasoning suggests that the retail supervisor's total compensation in this hypothetical would not depend on her FLSA status.[7]
The new tax treatment of overtime compensation changes this analysis.
The hypothetical salaried exempt retail supervisor who earns $1,500 per week will earn less after taxes than a nonexempt retail supervisor who also works 50 hours per week but is paid a base hourly rate of $27.27 plus overtime compensation.
If the hypothetical supervisor works 50 weeks per year, more than $6,800 in annual overtime compensation, representing about 9% of their total annual compensation, will be exempt from federal income tax only if the supervisor is classified as nonexempt from the FLSA.
The result of the change in the tax law is that millions of workers in occupations like firstline retail supervisors, who are currently exempt employees and do not receive overtime payments despite working long hours, would benefit from a reclassification to nonexempt FLSA status.
Litigation Risk and Compliance Costs
The change in the tax code may well increase the number of misclassification lawsuits, because exempt employees may challenge their FLSA classification, especially if there are employees in similar positions at other businesses who are classified as nonexempt and benefit from no tax on overtime.
Employers that respond to the new tax law by reclassifying some exempt employees as nonexempt should be prepared for higher litigation costs from possible wage and hour lawsuits. And there are a range of potential future lawsuits that could occur.
Disputes may arise over alleged off-the-clock work, including work that is conducted either preshift or postshift.
Additionally, new nonexempt workers may allege that their overtime premium does not equal one-half of their regular rate of pay, and that certain nondiscretionary bonuses are not properly accounted for in rate calculations.
Finally, workers who are reclassified as nonexempt may be subject to state minimum wage laws and could allege missed meal or rest breaks.
Many employers are likely to face higher costs due to the change in the tax law.
Businesses that employ nonexempt employees who do not receive a deduction for overtime compensation face the risk that their employees may leave for a similar job that is nonexempt and that benefits from the deduction for overtime pay.
To mitigate this uptick in turnover, businesses may increase pay for exempt employees so that their after-tax compensation is competitive with the after-tax pay of nonexempt employees who have similar skills and perform similar work.
Employers that choose to reclassify some of their exempt employees to nonexempt will face a variety of new compliance costs. These costs include, but are not limited to, the following.
First, as explained in the example above, employers need to have an accurate measure of the length of the typical workweek in order to set the hourly wage rate for reclassified workers.
While management may know that the typical workweek is about 50 hours for supervisors who earn $1,500 per week, costs will likely be incurred to study and measure the anticipated hours worked each week before these workers are reclassified and regular rates of pay are set.[8]
New nonexempt employees who were previously not recording the hours worked each day, and who are unaccustomed to clocking in and out, will need to adjust to a new timekeeping system.
These employees may initially record their work time with some inaccuracies, which will generate additional costs. For some employers, the new timekeeping system may also require some explicit setup costs.
Management is expected to monitor the activities of the new nonexempt employees more closely to make sure they are engaging in productive activities while on the clock, which is an opportunity cost for managers.
While new nonexempt employees benefit from their increased take-home pay due to no tax on overtime, they may also be less satisfied with the increased monitoring by management, the requirement to accurately track their hours worked and the fluctuation in their compensation from one pay period to the next.
Finally, certain aspects of the typical workweek may change if employees are reclassified as nonexempt simply due to the change in the tax treatment of overtime.
Management may allow less remote work and may limit email and other communication after typical work hours for the new nonexempt employees. These changes may increase costs by reducing the efficiency of the previously exempt employees.
Conclusion
The new no-tax-on-overtime provisions of the One Big Beautiful Bill Act provide tax relief for employees who are nonexempt from the FLSA and regularly work overtime.
This benefit does not extend to the millions of salaried workers who engage in similar work and also work more than 40 hours per week.
Many employers will now consider reclassifying certain of their salaried exempt employees to take advantage of no federal income tax on overtime premium compensation.
This article explains why employers should exercise caution in making these decisions. While reclassified employees may pay less in federal income taxes, their employers will likely face higher FLSA compliance costs and increased future wage and hour litigation.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
CITATIONS
[1] BILLS-119hr1enr.pdf also known as the One Big Beautiful Bill Act (OBBBA) or Public Law 119-21, https://www.congress.gov/119/bills/hr1/BILLS-119hr1enr.pdf.
[2] Recent Department of Labor (DOL) rules for setting the salary threshold for the white-collar FLSA exemption have relied on the number of employees paid by the hour, as reported in the CPS, as a proxy for the number of nonexempt employees because no DOL survey tracks the number of exempt or nonexempt employees.
[3] The details of the no-tax-on-overtime provisions are found in Section 70702 of the law.
[4] For example, employees who earn two times (instead of 1.5 times) the regular of pay rate for overtime work, can only deduct one-half the regular rate times overtime hours worked from their income for federal personal income taxes.
[5] According to the DOL the Standard Occupation Code title for this job is "First-Line Supervisors of Retail Trade Workers."
[6] The DOL, in rules for establishing the salary threshold for the white-collar overtime exemption, has cited a General Accounting Office study that indicates that 50% to 90% of workers in this occupation would satisfy the white-collar duties test for the overtime exemption.
[7] This economic argument is presented in "The Effects of Overtime Pay Regulation on Worker Compensation" by Stephen J. Trejo, The American Economic Review, Vol. 81, No. 4 (Sep., 1991) pp. 719-740. The DOL has cited this research in its rules for establishing the salary threshold for the white-collar overtime exemption. If overtime hours are variable and less predictable it is less clear what hourly rate (plus overtime premium) would cause a hypothetical worker to be indifferent between exempt and nonexempt FLSA status.
[8] Without an accurate measurement of anticipated hours worked the new hourly wage could be set too high or too low relative to the goal of maintaining roughly constant weekly compensation after the reclassification.
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