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This Tax Alert discusses the federal income tax treatment of paid family and medical leave (PFML) contributions and benefits under certain state business and personal income tax regimes. These questions are arising as a growing number of states enact laws to provide income replacement for employees who take leave from work due to their own illness or life event or that of a family member.

The primary federal income tax questions that arise are:

1. Are the employee's contributions into the state insurance system deductible from income?
2. Are the employer's contributions on behalf of its employees into the state insurance system taxable to the employee?
3. Are employee benefits paid from the state insurance system taxable to the employee?

Background

Congress enacted the Family and Medical Leave Act in 1993 (FMLA) to protect the jobs of employees taking extended leaves to care for themselves or family members. The key FMLA provisions protect such workers when leave is taken:

• For the birth of a child and to care for the newborn child within one year of birth
• For the placement with the employee of a child for adoption or foster care and to care for the newly placed child within one year of placement
• To care for the employee's spouse, child, or parent who has a serious health condition
• For a serious health condition that makes the employee unable to perform the essential functions of his or her job

or

• For any qualifying exigency arising out of the fact that the employee's spouse, son, daughter, or parent is a covered military member on "covered active duty"

Several states have enacted similar family and medical leave (FML) laws giving additional — and generally more generous — protections than those under the federal FMLA. None of these state FML laws require the provision of paid leave, although certain states do require employers to provide paid sick leave for the employee's own illness or to allow employees to use available leave for FML.

More recently, some states have begun enacting their own PFML laws. To date, all state PFML laws are structured as state insurance systems funded by payroll taxes. They vary widely, however, on the following issues: determining which party bears the burden of paying the state payroll tax to fund the state insurance system; whether employers offering a private plan are excepted from the state insurance system; and under which state agency's jurisdiction the PFML-sponsored program resides.

In addition, from a federal income tax perspective, neither the Treasury Department nor the IRS has provided guidance on the federal income tax treatment of contributions to, and benefits received from, these new state-sponsored programs. The 2019–2020 Priority Guidance Plan released by Treasury and the IRS on October 8, 2019, includes a new guidance project on these issues. In the meantime, states with newly-enacted PFML statutes, such as Massachusetts, have asked the IRS for guidance on these federal income tax matters. Until such guidance is released, employers and employees must seek their own tax advice.

Tax treatment of contributions

Broadly, the state PFML laws impose contribution requirements in the form of state tax payments to fund the state insurance system. The state taxes that have thus far been enacted tend to fall into four structural categories: (1) taxes imposed only on the employer, (2) taxes imposed only on the employee, (3) taxes imposed on both the employer and the employee, and (4) taxes imposed on the employer with an option for the employer to deduct certain amounts from employee wages.

Taxes imposed only on the employer

The District of Columbia will fund its PFML insurance system with a payroll tax imposed only on the employer. Such a program seems to operate much like the Federal Unemployment Tax Act (FUTA). Under FUTA, these taxes are imposed on the employer with no corresponding employee share. FUTA and its state counterparts (i.e., the State Unemployment Tax Acts (SUTA)) jointly finance mostly state-run programs that pay benefits to qualifying unemployed workers. Although employees may ultimately benefit from the unemployment insurance coverage funded by FUTA, for federal income tax purposes, the coverage funded by the tax assessed on the employer is not treated as taxable compensation to the employees. One would expect, therefore, that employees would not be subject to federal income tax on the amounts paid by employers under the District of Columbia PFML system.

Taxes imposed only on the employee

California, Rhode Island, and Connecticut will each fund its PFML insurance system with a payroll tax imposed only on employees. Because California's statute was enacted in 2002 — well before the recent trend — federal guidance exists on the taxation of these employee contributions. In CCA 200630017, the IRS analyzed the tax treatment of amounts withheld from employee paychecks under the California law. Although the CCA advises on whether the employee may claim the contributions as a deductible state tax under IRC Section 164, rather than whether the initial contribution may be withheld pre-tax, one may infer that the contribution at issue was post-tax because a pre-tax deduction would have mooted the question.

If an employee has received something of value as compensation for services, that value may be excluded from his or her income or wages only if there is a statutory exclusion. In this case, the only exclusion that might apply is provided under IRC Section 106, which excludes from income employer-provided coverage under an accident or health plan. Notably, contributions made by an employer for the payment of disability benefits are excludible from the gross income of covered employees under IRC Section 106 (See Revenue Ruling 72-191). For PFML insurance, however, the coverage is broader than disability coverage, potentially covering individuals and events that are not within the scope of IRC Section 106.

It is helpful to look to analogous situations to understand whether the broader scope of the new PFML taxes comports with the accident or health plan benefits described in IRC Section 106, and thus potentially renders IRC Section 106 entirely inapplicable to the payments made by the employee. For example, before the Supreme Court decision in United States v. Windsor (570 U.S. 744 (2013)), federal law did not recognize same-sex marriage. As a result, health coverage of a same-sex spouse (who was not otherwise a dependent) fell outside the scope of IRC Section 106, which is limited to an employee, the employee's spouse, the employee's dependents, and any child under age 27 (Treas. Reg. Section 1.106-1). (An unmarried domestic partner, same sex or otherwise, still falls outside the scope of IRC Section 106.) This limitation, however, did not render the coverage fully includible in income. Rather, family coverage that extended to a domestic partner was includible in income only to the extent of the fair market value of the coverage being provided to the domestic partner (PLR 200339001). Carrying over this logic to PFML coverage, IRC Section 106 ought to logically be read to exclude from income the portion of the state tax paid by the employee for the PFML coverage that is allocable to individuals and events within the scope of IRC Section 106. That is, the value of coverage for the potential leave taken for an accident or health reason of the employee or the employee's spouse or dependents should be excludable from income.

This conclusion, while intellectually consistent with precedent, presents practical complexities because it would require valuation and allocation of elements of coverage. Even the basic question of how to value health coverage is so challenging that Treasury and the IRS have never published regulations explaining how to do this for purposes of COBRA continuation health coverage. As a result, taxpayers seeking to exclude some portion of the PFML contribution from income would face a complex undertaking with little guidance. Moreover, as discussed later, it may be to the participant's advantage to avoid the question and pay for the coverage with post-tax dollars to allow for certain PFML benefits to be excluded from income.

Taxes imposed on both the employer and the employee

New Jersey, New York, and Oregon fund (or will fund) their PFML programs through taxes imposed on both employers and employees. This structure is analogous to the Federal Insurance Contributions Act (FICA), which imposes a 15.3% tax, composed of equal employer and employee shares. Under FICA, an employer must withhold the 7.65% employee share from an employee's wages and remit that share, together with the employer's own share of the FICA tax, to the IRS. Due to this remittance obligation, an employer that fails to collect the tax from its employees is liable for the full amount of the tax (Treas. Reg. Section 31.3102-1(c)). If an employer agrees to pay an employee's share of the FICA tax, rather than withhold it from wages owed to the employee, the additional payment is taxed to the employee as additional income and wages (Revenue Ruling 86-14). Nevertheless, an employer's inadvertent failure to withhold taxes is not taxable to the employee, provided the employee reimburses the employer or the tax is later deducted from the employee's wages upon discovery of the error (Revenue Ruling 74-75).

For PFML taxes imposed separately on the employer and the employee, it would appear that the taxation would generally track the methods applied to FICA, which would treat the wages from which the employee's share is deducted as income and wages while disregarding the employer's payment of its share. The nuance, however, is that IRC Section 106 should allow the employee's share to be paid with pre-tax wages to the extent that IRC Section 106 is deemed to correctly apply to such payments. As discussed previously, it is unlikely that IRC Section 106 would currently be read to fully exclude the employee's share of such taxes from income.

Taxes imposed on the employer with the option to deduct certain amounts from employee wages

Massachusetts and Washington recently enacted PFML statutes that impose a payroll tax on the employer but also permit a portion of the tax to be deducted from an employee's wages. This structure is distinct from FICA in that the tax obligation is affirmatively imposed only on the employer; in contrast, FICA separately imposes obligations on the employer under IRC Section 3111 and the employee under IRC Section 3101.

If the employer elects to pay the full amount, and thus does not deduct anything from compensation paid to the employee, it must be considered whether the amount paid by the employer ought to be treated as imputed income to the employee to the extent that the employer was permitted to deduct the amount from the employee's wages but chose not to do so. It is a basic tenet of federal income tax law that paying another's tax liability is treated as income to the individual who has the liability. For this reason, taxes assessed against an employee and paid by an employer in consideration for services should be treated as includible in the employee's gross income (Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) (holding that an employer's payment of an employee's federal and state income taxes was tantamount to a payment of the same amount directly to the employee and thus, should be treated as gross income of the employee)).

Under Massachusetts's and Washington's PFML statutes, however, the tax liability appears to be imposed only on the employer, with a limited permission to recover some portion from its employees. If the employer does not seek to recover that portion, these statutes appear not to impose any tax liability on the affected employee. As a result, the stronger analysis appears to be that no income should be imputed to the employee.

If, on the other hand, the employer deducts a permitted portion of the tax, the question becomes whether the deducted amount should be treated as wages paid to the employee and thus, includible in the employee's gross income. In this case, the analysis will again depend on the extent to which IRC Section 106 applies.

Tax treatment of benefits

Given the variety of reasons for which one might receive a PFML benefit under the various state laws, the federal income tax treatment of the benefits may vary as well.

At the outset, the applicability of the general welfare exclusion to the payments must be considered. Although no statutory exclusion exists, the IRS has administratively developed a general welfare exclusion from gross income for certain payments to individuals by governmental units under legislatively-provided social benefit programs for the promotion of the public's general welfare.

To qualify under the general welfare exclusion, payments must (1) be made from a governmental fund, (2) be for the promotion of general welfare (i.e., generally based on individual or family needs such as housing, education, and basic sustenance expenses), and (3) not represent compensation for services. The IRS typically rejects the applicability of the general welfare doctrine for payments that are not means-tested (see, for example, Revenue Ruling 76-131, Revenue Ruling 2005-46). The state programs enacted thus far appear to pay benefits if the leave is taken for a specified reason, without regard to need. Moreover, the payments might be viewed as intended to replace compensation that would have been received for services, much like sick leave. As a result, it is unlikely that the IRS would view the general welfare exclusion as applicable to amounts paid from the state PFML systems.

If the benefit is received for leave taken for one's own serious health condition, the benefit would be taxed in the same manner as a disability benefit. That is, the exclusion provided under IRC Section 104 for amounts received through accident or health insurance would exclude the benefit from the recipient's income to the extent it was attributable to an employee's post-tax contributions. If the benefit were funded with employer dollars (either as pre-tax salary reduction or otherwise), IRC Section 104 would not exclude the income. Whether funded with employee or employer contributions, IRC Section 104 also would not exclude income if the reason for the leave was injury or sickness of someone other than the employee due to IRC Section 104's limitation to "personal injuries or sickness." To further complicate the treatment of PFML payments under IRC Section 104, the taxation of disability benefits for an arrangement funded by a mix of employer and employee dollars is particularly complex.

IRS guidance generally requires a three-year look back to account for the ratio of employer-to-employee dollars to determine the proper portion that is excludable from income. Due to this complexity and the fact that a premium amount paid is likely to be less than a later benefit, disability benefits are often structured to pay the premium with post-tax dollars to allow the benefit to be tax-free.

If the benefit is received for other reasons, the IRS's analysis in CCA 200630017 is informative. In that advice, the IRS determined that California's FML benefits are "in the nature of unemployment compensation." IRC Section 85 expressly includes unemployment compensation in income. In parsing through IRC Section 85 to determine what would be treated as unemployment compensation, the CCA notes IRC Section 85's legislative history, which provides that "unemployment compensation programs are those designed to provide cash benefits on a regular basis to normally employed workers during limited periods of unemployment." Moreover, the statutory motivation was to tax amounts that are, effectively, a substitute for taxable wages. Accordingly, benefits paid under the California PFML program are includible in income under IRC Section 85. It follows that benefits under the more recently enacted state PFML programs would also likely be included in the income of the recipients.

The CCA goes on to consider whether the employee contributions are deductible by the employees as a state income tax under IRC Section 164(a)(3). The CCA concludes that the employee contributions are a deductible state income tax. Current forms provide instructions consistent with this conclusion. The Instructions for the 2019 Form 1040, Schedule A advise that mandatory contributions to state family leave programs are deductible state and local taxes for federal income tax purposes, which are now subject to the $10,000 annual limitation on such deductions. The Form 1099-G recipient instructions further advise that contributions to a governmental paid family leave program should reduce income from the program either via an itemized deduction or by reducing the amount included in income by the employee's previous contributions to the fund. These instructions create a difference between employees who itemize and those who do not itemize. Specifically, employees who itemize would deduct a post-tax contribution in the year of contribution, subject to the cap and without regard to whether the employee received a benefit from the fund. In contrast, a non-itemizing employee would reduce the income reported on the Form 1099-G by all prior contributions into the fund, without regard to the tax year. It is not clear whether an employee whose itemized deduction was lost due to the cap on state and local tax deductions in an earlier year might use the unclaimed amount to offset family and medical leave benefit income when received in a later year.

Implications

Because of the wide variation in the PFML programs established by the states, there is no "one size fits all" answer to the federal income tax treatment of both the taxes paid and the amounts received as benefits under these programs.

Critically, employers and employees first need to consider the underlying state law for the PFML in which they participate and determine whose legal obligation is being satisfied when considering the federal income tax treatment of both the contributions to and the benefits paid under each state PFML program.

While analogies may certainly be drawn to the treatment of taxes paid to and amounts received from the FICA system, the contributions for employers and employees under these new state PFML programs are created under a different legal construct, so one cannot assume that the same federal income treatment applicable to FICA applies to these systems.

Application of the rules under IRC Section 106 for accident and health plans to these new state PFML programs is also fraught with practical difficulties given that these state PFML programs cover events that technically fall outside the specific scope of IRC Section 106.

Guidance from the IRS and Treasury certainly appears necessary to give employers and employees alike greater certainty on how these contributions should be reported and whether any of the benefits received are taxable.

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