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Compensatory Time Off (CTO) Payments as Qualified Overtime Compensation

Compensatory Time Off (CTO) payments are reported as qualified overtime compensation in the year they are paid, not when the time is earned. This clarification was provided in IRS Notice 2025-69, which resolved prior uncertainty around the treatment of CTO for the One Big Beautiful Bill Act overtime deduction.


Key Points to Understand

  • Compensatory Time Off (CTO) is earned at a rate of 1.5 hours for each overtime hour worked (per FLSA guidelines).
  • Compensatory Time Off (CTO) is not reportable when earned and banked.
  • Compensatory Time Off (CTO) becomes reportable only when:
    • The employee uses the time (takes paid time off), or
    • The employee cashes out unused Compensatory Time Off (CTO) hours
  • Only one-third of the Compensatory Time Off (CTO) payment is considered qualified overtime compensation.


Why One-Third?

The one-third portion represents the “overtime premium” (the extra half-time) included in the 1.5x accrual rate. This aligns with the definition of qualified overtime compensation as the amount paid above the employee’s regular rate.

Examples:

  • Compensatory Time Off (CTO) Usage Example: An employee is paid $4,500 for Compensatory Time (CTO) time taken. Reportable amount: $1,500 (one-third)
  • Compensatory Time Off (CTO) Cash-Out Example: An employee cashes out $6,000 in unused CTO hours. Reportable amount: $2,000 (one-third)

 

Reporting Requirement

Beginning with tax year 2026, the reportable one-third portion of CTO payments must be included in Box 12 of Form W-2 using Code TT.

This approach ensures consistent and compliant reporting while clearly separating regular earnings from the overtime premium portion of CTO payments.

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