Public agency employers are no strangers to complex wage and hours rules, but the recently enacted “One Big Beautiful Bill Act” (OBBBA) raised new questions with the introduction of the deduction for qualified overtime compensation. See LCW’s prior blog post about the OBBBA. While the focus of the OBBBA’s overtime deduction has been on overtime payments, the IRS provided information in December 2025 clarifying that payments for compensatory time off (CTO) also count as qualified overtime compensation for the deduction. As public agency employers get ready to report the amounts of qualified overtime compensation for non-exempt employees for 2026, it is crucial that they remember to include CTO payments.

What is CTO?

Generally speaking, compensation for Fair Labor Standards Act (FLSA) overtime must be in the form of cash payment. However, the FLSA permits public agencies to compensate employees for FLSA overtime in the form of CTO, subject to an agreement and certain conditions and limitations. When an employee chooses to accrue CTO in lieu of overtime pay in cash, each hour of FLSA overtime worked is credited with one-and-one-half hours of CTO in the employee’s CTO bank. The employee may then use their CTO hours as paid time off in the future or may cash out CTO hours that go unused at the regular rate of pay.

CTO Payments Are Reported As Qualified Overtime Compensation In The Year Paid

Until December 2025, it was unclear if FLSA overtime earned as CTO was reportable as qualified overtime compensation for the OBBBA overtime deduction. The ambiguity has now been resolved. IRS Notice 2025-69 affirmatively states that an individual who works for a state or local government agency that provides CTO at a rate of one and one-half hours for each FLSA overtime hour worked should include one-third of those CTO payments as qualified overtime compensation.

The IRS further specified that CTO is only reported when hours are used or cashed out, not when CTO hours are earned and banked for future use.  A CTO payment can be provided when an employee takes time off using their accrued CTO hours or otherwise cashes out unused CTO hours.

Examples

Notice 2025-69 provides the following example illustrating how to take a CTO payment and calculate the reportable qualified overtime compensation amount:

Example 6. Individual D works for a State or local government agency that gives compensatory time at a rate of one and one-half hours for each overtime hour worked under 29 USC 207(o). In 2025, Individual D was paid wages of $4,500 with respect to compensatory time off taken in accordance with section 207(o). For purposes of determining the amount of qualified overtime compensation received in tax year 2025, Individual D may include $1,500, one-third of these wages for purposes of determining qualified overtime compensation under section 225(c).

The following is an example of how a CTO cash out payment is reported as qualified overtime compensation:

CTO Cash Out Example: Mary works for a local government agency that gives compensatory time at a rate of one and one-half hours for each overtime hour worked under 29 USC 207(o). In 2025, Mary did not take any paid time off using CTO, but pursuant to an applicable memorandum of understanding, Mary was able to cash out $6,000 of unused CTO hours. Mary may include $2,000, one-third of the CTO cash out payment for purposes of determining qualified overtime compensation under section 225(c).

As demonstrated in these examples, only one-third of the CTO payment is reported as qualified overtime compensation. The OBBBA defines “qualified overtime compensation” as the overtime compensation paid to an employee in excess of the regular rate of pay. The one-third amount represents the excess “overtime premium,” which is generally the “half” portion of the “one and one-half times” multiplier CTO hours are banked at for every FLSA overtime hour worked (i.e., 1.5 hours of CTO for every 1 hour of FLSA overtime).

One-third of the CTO payment is included in the total qualified overtime compensation amount reported in Box 12 of the employee’s Form W-2 using Code TT beginning for tax year 2026.

FLSA CTO vs. Non-FLSA CTO

Any public agency that provides employees with CTO for hours that are not FLSA overtime hours will have an additional challenge. This is because the OBBBA’s overtime deduction only applies to payments for FLSA CTO. FLSA CTO is based on hours that are accrued for working FLSA overtime. The FLSA defines overtime as hours actually worked in excess of the applicable threshold of the employee’s FLSA work week or work period (e.g., over 40 hours worked in a 7-day work week for non-safety employees, and the specific overtime threshold for a designated 7(k) work period for safety employees, if adopted). Thus, only CTO hours granted for working hours in excess of the applicable FLSA maximum hours threshold will be considered FLSA CTO hours. 

Some agencies provide CTO for hours worked that are not FLSA overtime hours pursuant to a negotiated memorandum of understanding or other contract or policy. For example, if an agency provides CTO hours for hours worked in excess of 8 hours in a day, for hours worked outside of an employee’s regular schedule, or for work on weekends or holidays, those hours do not automatically count as FLSA CTO hours. These hours are referred to as non-FLSA CTO hours. These hours only become FLSA CTO hours if they push the employee’s total hours worked over the applicable FLSA threshold in the work week or work period. 

Since only FLSA CTO payments can be used for the OBBBA overtime deduction and employers must accurately report qualified overtime compensation for the deduction, employers need to distinguish between FLSA and non-FLSA CTO hours and payments. Any agency that cannot separate the different types of CTO should seek advice from legal counsel on how to calculate the qualified overtime compensation. In light of the IRS’s clarification, public agency employers should take proactive steps now to ensure their payroll systems and reporting practices properly capture CTO payments as qualified overtime compensation under the OBBBA. This includes not only identifying when CTO is paid out, but also carefully distinguishing between FLSA and non-FLSA CTO to avoid overreporting eligible amounts. Thoughtful planning and accurate recordkeeping today will help minimize risk and ensure agencies are well-positioned to meet these new obligations.