On September 24, 2018, the Internal Revenue Service published guidance on the employer credit for paid family and medical leave, which was created by the Tax Cuts and Jobs Act and codified as Section 45S of the Internal Revenue Code. Notice 2018-71 (the Notice) provides clarification on important issues, such as qualifying leave types, minimum eligibility requirements and how to calculate the credit.

Credit overview

In general, Section 45S provides a tax credit to employers that voluntarily pay qualifying employees on leave for certain purposes recognized by the Family and Medical Leave Act of 1993 (FMLA). A qualifying employee is one employed for at least one year and paid less than a certain amount. To be eligible, the employer must have a written policy that provides at least two weeks of paid leave at 50% of normal wages to all qualifying full-time employees and a prorated amount to all qualifying part-time employees.

Employers that pay 50% of wages may claim a credit equal to 12.5% of those wages; the applicable credit percentage increases 0.25 percentage points for each percentage point above 50%. In a tax year, the employer may take into account up to 12 weeks of leave per employee. Leave available for non-FMLA purposes (such as vacation leave, personal leave, or other medical or sick leave) does not qualify for the credit.

Notice 2018-71

The guidance in Notice 2018-71 is presented in a question-and-answer format. In addition, the Notice indicates that: (1) the credit will be claimed on Form 8994, which has yet to be published, and (2) the IRS and Treasury intend to publish proposed regulations. To assist in the development of the proposed regulations, interested parties are invited to submit comments on the guidance in Notice 2018-71 no later than November 23, 2018.

Transition rule (Question 6)

In general, the Notice provides that wages are not eligible for the credit unless the paid family and medical leave is provided under an adopted, effective, written policy of the employer that satisfies all the requirements of Section 45S by the time the leave is taken. For employers that do not currently have written policies in effect that satisfy all minimum requirements, the Notice provides transition relief. The transition rule considers a written policy to be in place as of the policy's effective date, rather than a later adoption date. Although the transition relief applies equally to new written leave policies and amendments to existing policies, it only applies to the employer's first tax year beginning after December 31, 2017. The first example in Question 6 describes the transition rule:

Example 1: Employer's tax year is the calendar year. Employee takes two weeks of unpaid family and medical leave beginning January 15, 2018. Employer adopts a written policy that satisfies the requirements of [Section] 45S on October 1, 2018, and chooses to make the policy effective retroactive to January 1, 2018. At the time the policy is adopted, Employer pays Employee (at a rate of payment provided by the policy) for the two weeks of unpaid leave taken in January 2018.

Conclusion: Assuming all other requirements for the credit are met, Employer may claim the credit with respect to the family and medical leave paid to Employee for the leave taken in January 2018.

As described in the example, an employer must take certain time-sensitive steps to qualify for the transition. First, the policy or amendment must be adopted on or before December 31, 2018. Second, the employer must bring its leave practices into compliance with the terms of the retroactive policy for the entire period covered by the policy. Third, the employer must make any retroactive leave payments by the last day of the tax year.

Short-term disability (Question 11)

The Notice permits paid leave provided under an employer's short-term disability program, whether self-insured by an employer or provided through a short-term disability insurance policy, to be characterized as family and medical leave under Section 45S if it otherwise meets the requirements to be family and medical leave under Section 45S.

Qualifying employees (Questions 12, 13, 14)

The Notice clarifies the definition of qualifying employee. The Notice confirms that an employee must have earned no more than a certain amount during the preceding year ($72,000 in 2017). Employers whose fiscal years are not the calendar year may choose to use as the "preceding year" either the employer's immediately preceding fiscal year or the calendar year ending in the employer's immediately preceding fiscal year.

With regard to the one-year employment requirement, an employer may use any reasonable method until further guidance is issued to determine whether an employee has been employed for one year or more. The Notice states that it would be reasonable to use the method set forth in 29 CFR Section 825.110(b) (FMLA regulations for determining 12 months of employment), but requiring employees to have worked 12 consecutive months would not be considered a reasonable method.

The Notice goes on to state that Section 45S does not require an employee to work a minimum of 1,250 hours of service to be a qualifying employee for purposes of the credit.

Policy cannot exclude any qualifying employees (Question 15)

The Notice clarifies that the policy may not exclude any classification of employees, including collectively bargained employees, if they are qualifying employees. The second example in Question 15 further clarifies that a policy that excludes leave for a pre-existing condition effectively excludes a classification of employees.

Part-time employees (Question 17)

Section 45S uses the definition of part-time employee set forth in Section 4980E(d)(4)(B) (an employee customarily working less than 30 hours per week). Until further guidance is issued, the Notice allows employers to use any reasonable method to determine how many hours an employee customarily works per week for the employer. The Notice specifies that the method set forth in 29 CFR Section 2530.200b-2 (Department of Labor regulations for calculating hours of service for certain employee benefit plans) is a reasonable method.

Wages normally paid to an employee (Questions 19 and 32)

The Notice states that overtime (other than regularly scheduled overtime) and discretionary bonuses are excluded from wages normally paid. For employees not paid as salaried or hourly, pending further guidance, an employer must determine wages normally paid using FLSA rules for regular rate of pay (29 CFR Section 778.109).

No uniform leave requirement (Question 20)

The Notice allows employers to vary the amount of paid leave provided for various FMLA purposes. Employers may provide more weeks of paid leave to certain classifications of qualifying employees as long as the minimum paid leave requirements are satisfied for all qualifying employees. For example, an employer may provide six weeks of annual paid leave for the birth or adoption of the employee's child at a rate of 100% of normal wages while only providing two weeks of annual paid leave at a rate of 75% of normal wages for other qualifying family or medical leave. Additionally, an employer that provides qualifying employees with 10 years of service an additional two weeks of annual paid FMLA leave may claim a credit for the additional two weeks as long as all other requirements are also satisfied. In addition, an employer need not provide paid leave for all permissible leave types, but must meet the minimum requirements for any type of paid leave for which the employer seeks a credit.

Leave paid by a state or local government or required by state or local law (Question 21)

The Notice states that an employer must independently satisfy the minimum paid leave requirements, including providing a rate of payment of at least 50% of normal wages without considering any of the amount paid as required by state or local law. An example sets out facts in which, under state law, an employee on family and medical leave concurrently receives (1) six weeks of benefits paid by a state insurance fund at a rate of 50% of the employee's normal wages plus (2) six weeks of annual paid family and medical leave paid under the employer's written policy at a payment rate of 30% of normal wages. Thus, the employee receives six weeks of annual paid family and medical leave at a payment rate of 80% of normal wages. The Notice states that the employer's policy does not independently satisfy the requirement to pay at least 50% of normal wages and therefore the wages paid under the employer's policy are not eligible for the credit.

501(c)(3) employers (Question 24)

The Notice clarifies that Section 501(c)(3) employers are not eligible for the credit, even if they have unrelated business income tax liability, because compensation paid by these employers does not constitute FUTA wages within the meaning of Section 3306(b).

Controlled groups and groups of businesses under common control (Question 33 and 34)

The Notice clarifies that each member of a controlled group of corporations and each member of a group of businesses under common control may separately elect to claim or not claim the credit. Therefore, under the Notice 2018-71, a single entity could elect not to provide paid family and medical leave to any or all of its employees and that decision would not negatively affect eligibility for the credit of another entity within the same controlled group or group of businesses under common control that provides paid family and medical leave satisfying the minimum requirements of Section 45S.

Implications

In general, to be eligible for the credit, an employer must have a written policy in place that offers an annual minimum of two weeks paid family and medical leave at 50% of normal wages to all qualifying full-time employees and a pro-rated amount to all qualifying part-time employees. A qualifying employee is one who has been employed for at least one year and was paid no more than $72,000 for the preceding year. The Notice clarifies that the paid family and medical leave policy must cover all qualifying employees in order for the employer to be eligible, although the policy need not be contained in a single document covering all aspects of the overall policy and benefits.

The Notice provides good news and bad news for employers that were exploring the adoption or modification of a paid leave program designed to qualify for this credit. On the positive side, the Notice provides transition relief to allow employers to make retroactive changes to existing paid leave programs to bring them into compliance with Section 45S requirements or retroactively adopt a new written paid family or medical leave policy. The Notice also provides welcome flexibility by permitting individual legal entities of a controlled group to opt out of the credit so that failure to offer paid family and medical leave to employees in one entity does not negatively impact the eligibility of another entity in the controlled group. The clarification that short-term disability paid under an insurance policy may be characterized as family and medical leave under Section 45S is also helpful.

However, the Notice supports some of the concerns that employers had over the ability to implement a policy that complies with all of the requirements of Section 45S. For example, employers were hopeful that the IRS might announce a carve-out for union employees. However, the Notice did not provide any relief in that area. This means that an employer entity with union employees will likely have to bargain over providing this paid leave to those employees before it can adopt a written policy that satisfies the Section 45S requirement of covering all employees.

Another major impediment is the lack of a carve-out for payments that employers must make under governmentally required leave policies. With so many jurisdictions mandating such payments, most employers have been reluctant to provide sufficient additional benefits to meet the Section 45S minimum requirements. Lastly, the Notice does not address whether the use of ACA full-time determinations under Section 4980H would be a reasonable method of determining whether an employee is customarily employed at least 30 hours per week.

Check out our related publications

For information concerning the federal tax treatment of paid family and medical leave benefits and states that mandate this benefit, see our special report here. For information concerning the employer impact of the Tax Cuts and Jobs Act, see our special report here.

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