IRS Issues Ruling on Tax Consequences of State Paid Family and Medical Leave Acts

(Parker Tax Publishing January 2025)

The IRS issued a ruling on the income and employment tax treatment of contributions and benefits paid in various situations under a state, or District of Columbia, paid family and medical leave program, as well as the related reporting requirements. While the ruling is generally effective for payments made on or after January 1, 2025, the IRS is allowing for a transition period to provide states and employers time to configure their reporting and other systems and to facilitate an orderly transition to compliance with the ruling. Rev. Rul. 2025-4.

Background

The IRS received requests to clarify the federal tax treatment of state paid leave programs that help pay employees who cannot work because of non-occupational injuries to themselves or family members, as well as sickness and disabilities.

In Rev. Rul. 2025-4, the IRS responded to these requests with guidance on the income and employment tax treatment of contributions and benefits paid in certain situations under a state paid family and medical leave program, as well as the related reporting requirements.

Facts

In 2021, State X enacted a Paid Family and Medical Leave Act (PFML Act), which became effective on January 1, 2022. The PFML Act implemented a state-administered family and medical leave program to provide wage replacement to workers for periods in which they need to take time off from work due to their own non-occupational injuries, illnesses, or medical conditions, or to care for a family member due to the family member's serious health condition or other prescribed circumstance. The PFML Act indicates that the purpose of the statute is to provide a safety net for all employees in State X when they have personal or family caregiving needs and to advance the public interest by promoting the health, safety, and welfare of all residents of State X.

To fund State X's provision of benefits under the PFML Act, all in-state employers and employees are required to make contributions with respect to each employee to the State X Paid Family and Medical Leave Fund (PFML Fund) operated and administered by State X. State X collects these contributions from employers and deposits them into the PFML Fund for the purpose of providing the family and medical leave benefits described under the PFML Act to individuals covered by the PFML Act. These contributions must be equal to a specified percentage of each employee's weekly wages (computed in accordance with the PFML Act), referred to as the "standard contribution rate."

The State X Director of Employment determines the State X standard contribution rate for each plan year, which is based on the calendar year, before the beginning of such calendar year. For 2025, the State X standard contribution rate is set at 1 percent of each employee's weekly wages. While the State X PFML Act imposes a single contribution rate to a fund for both family and medical leave benefits, some states impose different contribution rates for remittance into separate family and medical leave funds.

Code Sec. 162 provides a deduction for all the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. Under Reg. Sec. 1.162-7, the test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services. Subject to certain limitations, Code Sec. 164(a)(3) permits a taxpayer to claim a deduction for certain state, local, and foreign income taxes paid or accrued during the tax year.

Under the flush language of Code Sec. 164(a), a taxpayer may also deduct taxes incurred in carrying on a trade or business activity. Generally, taxes may be deducted only by the taxpayer upon whom that tax is imposed.

Analysis

In Rev. Rul. 2025-4, the IRS sets forth the following federal income tax consequences of contributions by employers to state PMFL funds, and the federal income tax consequences of PMFL benefits paid to individuals by state PFML Funds.

1. Mandatory employee contributions that an employer withholds from an employee's wages and remits to the state pursuant to a state's PFML statute are employee payments of state income tax. Therefore, the employee may deduct these amounts under Code Sec. 164(a)(3) for the tax year in which such taxes are withheld by the employer. However, the employee may deduct these amounts only if the employee itemizes deductions in computing taxable income under Code Sec. 63 and only to the extent that the employee's deduction for state income taxes is not limited by the state and local tax (SALT) deduction limitation under Code Sec. 164(b)(6). According to the IRS, even though these amounts are withheld from the employee's wages, they are included in the employee's gross income (and wages for federal employment tax purposes under Code Secs. 3121(a), 3306(b), and 3401(a)), and the employer must report these amounts on the employee's Form W-2 in accordance with Code Sec. 6051.

2. Mandatory employer contributions required to be paid from the employer's own funds pursuant to the state's PFML statute are employer payments of state excise tax. Therefore, the employer may deduct these amounts as taxes incurred in carrying on a trade or business in the tax year they are paid or accrued by the employer under Code Sec. 164(a). Furthermore, these amounts are not included in the federal gross income of the employee under Code Sec. 61.

3. Amounts paid to the employee by the state as family leave benefits pursuant to the state's PFML statute are included in the federal gross income of the employee under Code Sec. 61. However, these amounts are not wages for federal employment tax purposes under Code Secs. 3121(a), 3306(b), and 3401(a). Nevertheless, the state must file with the IRS and furnish to the employee a Form 1099 to report payments of these amounts if they aggregate $600 or more in any tax year in accordance with Code Sec. 6041 and Reg. Sec. 1.6041-1.

4. Amounts paid to the employee by the state as medical leave benefits that are attributable to the employee's contribution pursuant to the state's PFML statute are excluded from the employee's gross income under Code Sec. 104(a)(3) and are neither wages for federal employment tax purposes under Code Sec. 3121(a) and Code Sec. 3306(b) nor treated as sick pay, as defined in Code Sec. 3402(o). Amounts paid to the employee by the state as medical leave benefits that are attributable to the employer's contribution pursuant to the state's PFML statute generally are included in an employee's gross income under Code Sec. 105, are wages analogous to the disability leave benefit payments described in Rev. Rul. 72-191 for federal employment tax purposes under Code Sec. 3121(a) and Code Sec. 3306(b), and are third-party payments of sick pay, as defined in Code Sec. 3402(o). The state must comply with the employment tax and reporting requirements that apply to such payments under Code Sec. 32 and other guidance.

5. If, as permitted by a state's PFML statute, the employer voluntarily pays from its own funds any part of the employee's otherwise required contribution, the amount of this employer pick-up is deductible by the employer as a business expense under Code Sec. 162. Moreover, this amount is additional compensation to the employee under Code Sec. 61 and included in wages for federal employment tax purposes under Code Secs. 3121(a), 3306(b), and 3401(a), and the employer must report it on the employee's Form W-2 in accordance with Code Sec. 6051. However, the employee may deduct the employer pick-up and mandatory contributions withheld from his or her wages as state income tax under Code Sec. 164(a)(3) to the extent permitted under Code Sec. 63 and Code Sec. 164(b)(6).

6. If, as permitted by the state's PFML statute, the employer voluntarily pays from its own funds any part of the employee's otherwise required contribution, the family leave benefit amounts attributable to this employer pick-up are included in the employee's federal gross income under Code Sec. 61 but are not wages for federal employment tax purposes under Code Secs. 3121(a), 3306(b), and 3401(a). Nevertheless, as with other family leave benefits, the state may be required to report the amounts in accordance with Code Sec. 6041 and Reg. Sec. 1.6041-1.

7. If, as permitted by the state's PFML statute, the employer voluntarily pays from its own funds any part of an employee's otherwise required contribution, the medical leave benefit amounts attributable to this employer pick-up are excluded from the employee's gross income under Code Sec. 104(a)(3) and are neither sick pay nor wages for federal employment tax purposes under Code Secs. 3121(a), 3306(b), and 3401(a).

The following IRS guidance is modified as a result of the ruling in Rev. Rul. 2025-4: Rev. Rul. 81-194, Rev. Rul. 81-193, Rev. Rul. 81-192, Rev. Rul. 81-191, and Rev. Rul. 72-191.

Rev. Rul. 2025-4 is generally effective for payments made on or after January 1, 2025. However, the IRS has provided that calendar year 2025 will be regarded as a transition period for purposes of IRS enforcement and administration of the information reporting requirements and other rules described in Rev. Rul. 2025-4. According to the IRS, this transition period is intended to provide states and employers time to configure their reporting and other systems and to facilitate an orderly transition to compliance with Rev. Rul. 2025-4.

For a discussion of the taxation of employee benefits involving family and medical leave, see Parker Tax ¶122,560. For a discussion of the SALT deduction limitation under Code Sec. 164(b)(6), see Parker Tax ¶83,101.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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