Alert / Employee Benefits
IRS releases guidelines for the new paid family and medical leave employer tax credit

The IRS recently issued long-awaited guidance in the form of FAQs relating to the employer tax credit available for qualifying paid family and medical leave passed under federal tax reform law enacted earlier this year. (See Benefits Insight & Guidance – February 2018). The FAQs offer more comprehensive guidance and explain:

  • Employer eligibility and requirements for applying for the tax credit.
  • How the FMLA governs qualified family and medical leave.
  • The minimum paid leave requirements.
  • How to calculate and file with the IRS to claim the tax credit.

When is an employer eligible to use the tax credit?

Although leave eligible for the credit must be defined as leave that would otherwise be eligible under the Family and Medical Leave Act (FMLA), even a small employer not otherwise subject to FMLA requirements may take advantage of the tax credit.

To be eligible for the tax credit the employer must have a written paid leave policy in place providing for paid family and medical leave. The policy must include coverage of all qualifying employees (described below) and must offer at least two weeks of paid family and medical leave at a rate of at least 50 percent of the employee’s normal wages (which does not include voluntary overtime or discretionary bonuses).

This period is prorated for part-time employees. A part-time employee is any employee who is customarily employed for fewer than 30 hours per week. If any qualifying employees entitled to leave would not be eligible to take leave under FMLA, the policy must include language permitting them to take leave even though they are not FMLA-eligible.

Lockton comment: The regulation offers sample language that may be used to satisfy this requirement. Because nearly all employers are likely to have an employee who might not have met the minimum hours required to be eligible to take FMLA, or who may have exhausted FMLA for a purpose other than one under the employer’s paid leave policy, all employers should include this noninterference language in their written policy.

The written paid leave policy must be in place before the employer may take the tax credit for any leave offered under that policy. There is some relief employers may take advantage of for the first tax year. Assuming the employer’s tax year is the calendar year, the written paid leave policy must be in place before the end of the 2018, provided the employer retroactively brings its leave practices into compliance (with the requirements for the paid family and medical leave tax credit) for the entire year. In that case, the employer will be eligible to take the tax credit for all of 2018.

Lockton comment: For employers that may use a tax year that differs from the calendar year, written policies must be in place by the end of the tax year that began after Dec. 31, 2017. Written policies must be in place as of, or prior to, subsequent tax years. For example, if the employer’s tax year begins June 1, written policies must be in place on or before June 1, 2019, for the 2019 tax year.

Although the employer’s actual written paid leave policy need not be provided directly to employees, employers must notify employees of the availability of qualifying paid leave. The notice must be distributed or made available in a way that is reasonably designed to reach employees. For example, an email with a link to an intranet posting may not be sufficient unless all employees have computer access as part of their day-to-day job responsibilities. Notice may be accomplished through various means such as the employee handbook, an intranet posting, a workplace poster, via mail or via email.

Lockton comment: Assuming the employer’s written paid leave policy is included in a single policy (rather than piecemeal in various human resources policies) and is written in a manner that is easily understood, providing a copy of that policy should satisfy the employee notice requirement.

Who is a qualifying employee?

The tax credit is available with respect to paid family and medical leave provided to a qualifying employee. A qualifying employee is one who has been employed for one year or more (like requirements for FMLA eligibility). The one-year requirement may not be based on the employee working 12 consecutive months, but any other reasonable method may be used to determine whether the one year has been satisfied. In addition, to be a qualifying employee the employee’s compensation in the preceding year cannot exceed an amount equal to 60 percent of the applicable compensation for that prior year as defined under IRC Section 414(q)(1)(b)(I) (generally used for retirement plan purposes to identify highly compensated employees).

Lockton comment: Thus, for 2018, to be a qualifying employee the employee could not have earned more than $72,000 in 2017 (60 percent of the compensation amount identified under the code section cited above, which was $120,000 for 2017). This compensation figure remains at $120,000 for 2018. So, for 2019, an employer may only take a tax credit for paid leave for employees who did not earn more than $72,000 during 2018.

How is FMLA used to define a qualifying leave for purposes of the tax credit?

Under FMLA, an employer must have a written policy that provides paid leave for any reason outlined under that law. While an employee need not be FMLA-eligible for the employer to take a tax credit for paid leave supplied under the new law, the employer’s paid family and medical leave policy intended to satisfy the new law’s requirements must use the same criteria.

Under FMLA, an employee may take leave for the employee’s own serious health condition; to care for a spouse, child or parent with a serious health condition; to bond with or care for a newborn and child newly adopted or placed for adoption; due to a qualifying exigency relating to a spouse, child or parent who is a member of the armed forces and who is on covered active duty; or to care for an insured or ill service member when the employee is that individual’s spouse, son, daughter, parent or next-of-kin.

Paid family and medical leave for one of the enumerated FMLA purposes is eligible for the new employer tax credit only if the leave cannot be used for any other purposes, is not paid by the state or local government, and is not required under state or local law.

Lockton comment: If paid family and medical leave can be taken for reasons other than those outlined in the FMLA, such as the employee’s minor illness, it does not qualify as leave for which an employer can take a tax credit. The employer may offer paid leave that includes leave for purposes other than those outlined under the FMLA, but doing so disqualifies the employer from taking the new tax credit.

Notwithstanding all of that, the FAQ does offer one exception to the rule that the paid leave, to qualify for new tax credit, must be leave described in the FMLA. If the employee is able take paid leave described under the FMLA but the leave is taken to care for an individual not covered by the FMLA (for example, a domestic partner or a grandparent), that will not cause the paid leave policy to render the employer ineligible for a tax credit. However, the employer may not take a tax credit for the leave that would not otherwise qualify as leave described the FMLA.

The FAQ also clarifies that leave taken under short-term disability program, whether fully insured or self-funded, may be characterized as leave eligible for the employer tax credit if it meets the FMLA requirements (other than for purposes of eligibility). However, to qualify for a tax credit the short-term disability plan must cover all employees and may not otherwise classify workers differently. Examples of impermissible classifications include the exclusion of collectively bargained employees, imposing a service requirement for coverage (e.g., coverage begins after six months of service) or imposing a pre-existing condition limitation (e.g., no coverage for an existing condition if the disability begins within the first 12 months of employment).

Lockton comment: The FAQ does offer an option to address deficiencies in short-term disability program coverage if not all employees are covered or if there are limitations in the coverage. If the employer provides a supplemental paid leave program offering benefits for an individual who would not otherwise receive payment under the short-term disability program, the employer may treat that supplemental coverage as satisfying the criteria that leave be available to all employees in the same manner. The paid leave offered under the short-term disability program and the supplemental disability program would allow a tax credit to be taken for paid leave under either program.

Can an employer vary the amount of leave and the amount of payment based on any employee classifications?

The amount of time available for paid leave, and the rate of pay, may vary based on employee classification provided that all employees are eligible for the minimum paid leave of 50 percent of wages for a two-week period (prorated for part-time employees). The following examples show how the rule outlined above might apply:

  • An employer offers paid leave to all employees for two weeks at 50 percent of pay for an employee’s serious health condition. An employee is eligible for an additional week paid at 100 percent for each five years of service she has completed unless she is a collectively bargained employee. This classification, even though it excludes bargaining unit employees from the enhanced leave benefit, is permissible in relation to obtaining a tax credit because all employees are eligible for the minimum required two weeks of leave paid at 50 percent.
  • An employer offers two weeks of 100 percent paid leave for bonding with a new child. The employer also offers two weeks of 50 percent paid leave for the employee’s own serious medical condition but excludes collectively bargained employees. In relation to the paid leave for bonding, the employer may take a tax credit because it meets the minimum requirements. In relation to the paid leave for the employee’s own serious health condition, the employer may not take a tax credit because the leave for that purpose is not available to all qualifying employees (because collectively bargained employees are excluded entirely).

The key is that for the employer to be eligible for a tax credit, paid family and medical leave for a specific purpose (e.g., bonding with a child) must be available to all employees but only for the minimum leave requirement (50 percent of pay for a two-week period). Further classification may be made for additional leave time and may be offered with modified pay schedules beyond the minimum two-week time period and the minimum required 50 percent level of pay.

How do you calculate the tax credit?

If an employer may claim a tax credit because qualifying paid family and medical leave was provided to a qualifying employee, the maximum number of weeks that may be considered for the credit is 12 weeks of paid leave per year per qualifying employee.

The amount of the tax credit is based on an applicable percentage calculated as follows: 12.5 percent for the first 50 percent of pay paid, plus .25 percent for each percentage point paid over 50 percent.

The aggregate total of the tax credit cannot exceed 25 percent (if the employer pays 100 percent of pay, the tax credit would equal 25 percent of pay).

Lockton comment: For example, an employer has a policy to pay 75 percent of pay for the first four weeks of qualifying leave. John, an employee, makes $500 per week. During the four weeks of leave he is paid $375 per week. The employer could take a tax credit of $70.31 per week for this employee. The amount of the tax credit equals 12.5 percent for the first 50 percent of weekly pay plus 6.25 percent of the remaining 25 percent of weekly pay, for a total of 18.75 percent of the amount paid, or $70.31 per week. For John’s four weeks, the employer is entitled to a tax credit of $281.24.

How are wages defined, and how does an employer obtain the tax credit?

Wages are defined as the amount used to calculate Federal Unemployment Tax Act (FUTA) payroll tax without regard to the $7,000 limit on FUTA-taxable wages. However, wages applied toward another business-related tax credit reduce FUTA-taxable wages for purposes of calculating the tax credit for paid family and medical leave. A tax-exempt organization is generally not eligible to take this tax credit because it does not pay wages subject to the FUTA tax.

Lockton comment: Employers should consult with their payroll vendor, tax advisor or accountant or determine how to make this calculation.

Wages paid during leave by a third party (including an insurance company) on behalf of the employer are considered wages and may be used for by the employer when determining if it is eligible for a tax credit.

An employer’s typical tax deduction for wages must be reduced by the amount of the tax credit it takes under the paid family and medical leave tax credit rules.

Employers may make an independent election to apply for a tax credit; they are not aggregated for this purpose if they are part of a controlled group of corporations, trades or businesses. To file for the tax credit an employer must file IRS Form 8994 (Employer Credit for Paid Family and Medical Leave) and IRS Form 3800 (General Business Credit) with its tax return.

Employer next steps

Employers who wish to take a tax credit should review current paid leave policies and update them as necessary before the end of their tax year to assure they meet the criteria outlined above.  When establishing new paid leave policies, employers should take into account these rules to obtain a tax credit to assure that new policies are in compliance as well.

Not Legal Advice: Nothing in this Alert should be construed as legal advice. Lockton may not be considered your legal counsel and communications with Lockton's Compliance Services group are not privileged under the attorney-client privilege.

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