22 January 2025 IRS releases guidance on tax treatment of state-paid family and medical leave contributions and benefits
In Revenue Ruling 2025-4 (the Revenue Ruling), the IRS analyzes the federal income and employment tax treatment of contributions and benefits paid in certain situations under a hypothetical state's law on paid family and medical leave (PFML). The Revenue Ruling also grants transitional relief for 2025 from certain withholding and reporting requirements. The IRS requests comments on additional situations and aspects of state PFML benefit programs by April 15, 2025. Before Revenue Ruling 2025-4, no published guidance addressed the taxation of, or reporting requirements for, state-paid PFML benefits. As a result, practitioners relied heavily on interpretations of IRC Sections 104, 105 and 106, which govern the taxation of accident or health insurance coverage and benefits, although it was unclear whether or to what extent PFML might constitute accident or health insurance.1 IRC Section 106 excludes the cost of coverage (but not benefits) under an accident or health plan from income subject to federal income tax (FIT). IRC Sections 3401, 3121 and 3306 separately exclude the cost of coverage from federal income tax withholding (FITW), Social Security/Medicare (FICA) and federal unemployment insurance (FUTA), respectively. These exclusions include employer-provided group health plans as well as disability coverage. Benefits paid under an employer-provided accident or health plan are excluded from income under IRC Section 105 only if they are reimbursements of an employee's medical expenses (or those of the employee's spouse, dependents or children under age 27). The same benefits are also excluded from wages subject to FITW, FICA and FUTA. Benefits, such as disability, that replace wages rather than reimburse medical expenses are not excluded from income under IRC Section 105. Certain disability payments that are not excludable from income are sometimes excludable from wages for purposes of FITW, FICA or FUTA, depending on the circumstances. IRC Section 104 excludes benefits paid through accident or health insurance plans regardless of whether the amounts are medical expense reimbursements, but only if the benefits were paid with employee after-tax contributions. Thus, a wage replacement benefit that is paid under an employer-provided accident or health insurance plan is excludable from an employee's income and wages only if the employee paid the cost of coverage with after-tax contributions. For this reason, disability coverage is often structured to give employees the opportunity to be taxed on the cost of the coverage/premium to eliminate future taxation of benefits. If the coverage is funded partially pre-tax and partially after-tax, the benefits are taxed in accordance with the contribution ratio of pre-tax dollars to after-tax dollars. The Revenue Ruling poses a fact pattern under which a hypothetical state's PFML statute provides wage replacement to employees who take time off for a variety of reasons, including the employee's own serious health condition (medical leave), a family member's serious health condition (family leave), bonding with a new child, dealing with exigencies related to covered active duty, or needs arising from domestic violence. The situations addressed in the Revenue Ruling concern the tax and reporting requirements for medical and family leave benefits paid by a state plan. Situation 1 considers the tax treatment of contributions to a state PFML fund that requires employers and employees to contribute a percentage of wages annually. Sixty percent of the contribution applies to employees via wage withholding, while 40% applies to employers.
Following the contributions made in Situation 1, the employee receives wage replacement payments from the state's PFML fund while on leave to care for a family member with a serious health condition. The Revenue Ruling concludes that the payments are income to the employee, reasoning that the arrangement is not accident or health insurance because it does not relate to the employee's own illness or injury. Nevertheless, the Revenue Ruling concludes that the payments are not wages, likening them to Social Security payments that are not treated as remuneration from employment. Accordingly, the state must report the payments to the employee on Form 1099 as income subject to FIT, but the payments are not reportable as wages subject to FITW, FICA and FUTA. Situation 3 is the same as Situation 2, except the employee's leave is taken for the employee's own serious injury or illness, which modifies the result. Because the leave relates to the employee's own health condition, the Revenue Ruling concludes that the arrangement is a benefit under an accident or health insurance plan. The payments are excluded from income to the extent that the coverage was paid by the employee and not the employer. As 60% of the employee's coverage was funded by employee after-tax contributions, 60% of the payment is not subject to FIT, FITW, FICA and FUTA. The remaining 40%, which the employer paid, is included in income and wages subject to FIT, FITW, FICA and FUTA. Because the state made the payment, it is treated as sick pay paid by a third party who is not an agent of the employer, so the reporting and withholding rules under Notice 2015-6 apply. These rules generally place the employment tax liability, and withholding and reporting obligations on the third party, unless the third party takes prescribed steps to transfer some of these obligations to the employer. Situation 4 returns to the treatment of PFML contributions, modifying Situation 1 such that the employer pays a portion of the employee's required contribution (referenced in the Revenue Ruling as an "employer pick-up"). To the extent each party is paying their own required contribution, the tax treatment does not change. The employer pick-up, however, is treated differently. The employer's pick-up contribution is not deductible as a tax incurred in carrying on a trade or business under IRC Section 164(a) but is deductible as a compensation expense under IRC Section 162(a). The employer's pick-up contribution is taxable to the employee and must be included in income and wages subject to FIT, FITW, FICA and FUTA and reported on the Form W-2. The employee may deduct the full amount of the employee's required contribution (including the amount paid on the employee's behalf) as a state income tax on the employee's federal personal income tax return, subject to the same limitations as in Situation 1. Situation 5 returns to the question of taxation of benefits, modifying Situation 2 (family leave) with the employer pick-up contribution arrangement of Situation 4. Situation 5's conclusion is identical to Situation 2's conclusion. That is, the payments are taxable income to the employee but not taxable wages, and the state must report the payments to the employee on a Form 1099. The employer pick-up makes no difference to the taxation of the family leave benefits. Situation 6 is to Situation 3 as Situation 5 is to Situation 2, analyzing the taxation of medical leave benefits when the contribution arrangement is modified to include an employer pick-up. Again, the outcome does not change. Although the employer actually paid both the employer and employee portions of the state tax, the employer is not viewed as funding a larger portion of the benefit. Rather, because the employee was taxed on the employer pick-up, the employee portion of the tax is still credited to the employee. Accordingly, as in Situation 3, 60% of the payment is excludable from income and wages, and the remaining 40% is included in income and wages subject to FIT, FITW, FICA and FUTA, reportable by the state under the rules for third-party sick pay. The IRS said in the Revenue Ruling that 2025 will be regarded as a transition period to give states and employers time to adjust their reporting systems. As such, states and employers are not required to comply with certain withholding and reporting requirements for 2025. PFML programs have been growing in number and changing in design for many years and remain in flux across the country. There are many issues to consider. The Revenue Ruling does not address the taxation and reporting of PFML benefits and contributions under a private plan, covers only the federal tax treatment of PFML, and does not address every possible iteration of PFML contributions and benefits. In addition, the Revenue Ruling did not specify the use of 1099-G for states reporting payments to employees, even though this is the form usually used by state agencies. Nevertheless, by analyzing a hypothetical program in detail, the guidance goes a long way toward making Treasury and the IRS's view clear on many of the building blocks necessary to reach conclusions on unaddressed situations. Specifically:
Questions remain regarding how the ruling's conclusions might translate to the treatment of private PFML plans. For example, the Revenue Ruling concludes that family leave under a state program is income but not wages, finding the nearest analogy to be Social Security benefits. It is unlikely that this conclusion translates to private arrangements. If privately-paid PFML is both income and wages, but is not third-party sick pay, it is unclear what rules govern responsibility for employment tax obligations, other than the statutory employer rules under IRC Section 3401(d). Similarly, the Revenue Ruling does not consider the possibility that contributions to private arrangements might be excludable under IRC Section 106 as coverage under an accident or health plan. It seems reasonable to infer that only contributions for coverage related to leave for an employee's own serious health condition might be excludable because Treasury and the IRS have rejected the notion that PFML more generally might constitute an accident or health plan. The Revenue Ruling does contemplate treating the state plan as composed of two arrangements, one for family leave and the other for medical leave. This approach, however, raises complexities of valuation and allocation. It is unusual for a revenue ruling to be prospective, provide a transition period and request comments. This suggests that the Revenue Ruling may not be the final word and that interested parties may benefit from accepting the invitation to share their perspectives with Treasury and the IRS.
Document ID: 2025-0297 | ||||||||