Paid Family and Medical Leave Employer Tax Treatment: Deductions, Credits, and Payroll Reporting

Paid family and medical leave (PFML) operates under two parallel tax regimes: mandatory state programs that impose contribution obligations on employers and employees, and the voluntary federal credit under IRC §45S that rewards employers who provide leave exceeding state minimums. The core tax rules are straightforward: mandatory employer PFML contributions are deductible ordinary business expenses under IRC §162; employee-withheld PFML contributions are pass-through withholdings and generate no additional employer deduction; PFML benefits paid by the employer are taxable wages to the recipient; and the §45S credit — made permanent by the One Big Beautiful Bill Act (OBBBA) — allows eligible employers a credit of 12.5%–25% of wages paid during qualifying family and medical leave. With mandatory state programs now covering employees in over a dozen jurisdictions, CPAs advising small and mid-size businesses need fluency in both layers.

The State PFML Landscape in 2026

Mandatory state PFML programs require employers to collect employee contributions, remit employer-share premiums where applicable, and coordinate with the state fund when employees take leave. Active programs as of 2026 include:

• California (SDI/Paid Family Leave): Employee-funded; no separate employer PFL premium. Benefits are taxable income at the federal level (IRS Notice 2020-54); California exempts them from state income tax.
• New Jersey (Family Leave Insurance): Employee-funded. Benefits taxable at federal level.
• New York (NY Paid Family Leave): Employee-funded via a capped per-employee annual deduction. Benefits are federally taxable; New York exempts them from state income tax.
• Massachusetts (MA PFML): Split contributions — employers with 25 or more employees pay an employer share alongside the employee deduction. Employer share is deductible under IRC §162.
• Washington (WA PFML): Split contributions — employers with 50 or more employees pay an employer portion; small employers pay only the employee share unless they voluntarily contribute. Employer share is deductible under IRC §162.
• Oregon (Oregon Paid Leave): Split contributions; employer share deductible under IRC §162.
• Colorado (FAMLI Act): Split contributions; employer share deductible under IRC §162.
• Connecticut (CT Paid Leave): Employee-funded; no employer premium.
• Rhode Island (TDI/TCI): Employee-funded via TDI payroll deduction; no employer premium.
• District of Columbia (DC PFML): Fully employer-funded — the employer pays the entire premium. Fully deductible under IRC §162.
• Maryland (TIME Act): Launched 2026. Split employer/employee contributions; employer share deductible.
• Minnesota (ESST/PFL): Launched 2026. Split contributions; employer share deductible.
• Delaware (Healthy Delaware Families Act): Launched 2026. Split contributions with employer share.

The key tax rule for all mandatory employer contributions: they are deductible as ordinary and necessary business expenses under IRC §162. They are not wages, are not subject to FICA, and do not appear in the employee's W-2. Employee-paid contributions are withheld post-tax from gross wages and remitted to the state fund; the employer deducts gross wages in full and has no additional deduction for the withheld amounts.

IRC §45S Employer Credit: Mechanics

Section 45S of the Internal Revenue Code provides a tax credit for employers who pay wages to employees on family and medical leave. Originally enacted by the Tax Cuts and Jobs Act as a temporary provision, §45S was extended by subsequent legislation and made permanent by the One Big Beautiful Bill Act.

Credit Rate: The base rate is 12.5% of wages paid during qualifying leave when the employer replaces at least 50% of normal wages. For each percentage point above 50% wage replacement, the credit rate increases by 0.25 percentage points, up to a maximum credit rate of 25% at 100% wage replacement.

Example: An employer pays 75% of normal wages during eight weeks of qualifying FMLA leave. The credit rate is 12.5% + (25 × 0.25%) = 18.75%. If normal weekly wages are $1,200, total wages paid during leave = $900 × 8 = $7,200. Credit = $7,200 × 18.75% = $1,350.

Qualifying Requirements:

1. Written policy: The employer must have a written paid family and medical leave policy in place before the leave begins. The policy must cover all qualifying employees — generally those employed at least 12 months with prior-year compensation at or below the annual threshold (currently $81,000, adjusted for inflation per IRS Rev. Proc. updates). No eligibility restriction beyond 12 months of service is permitted.
2. Minimum leave: At least two weeks of annual paid family and medical leave (prorated for part-time employees).
3. Wage replacement: At least 50% of the employee's normal wages during leave.
4. FMLA-qualifying reasons: Leave must be for a reason covered by the Family and Medical Leave Act of 1993 — birth or adoption of a child, serious health condition of the employee or a family member, or qualifying military exigency. Employers not subject to FMLA (generally those with fewer than 50 employees) are still eligible for §45S if they adopt a compliant written policy voluntarily.

What Does Not Qualify:

• State fund payments made directly to the employee do not generate a §45S credit — only wages the employer itself pays count.
• Paid sick leave, PTO, or vacation used for FMLA-qualifying reasons generally do not qualify unless the policy specifically designates those payments as paid family and medical leave under §45S.
• Leave payments required by a collective bargaining agreement that pre-dates the §45S credit period are excluded.

Deduction Reduction under IRC §280C(a): Employers claiming the §45S credit must reduce their deductible wage amount by the credit claimed. A $1,350 §45S credit reduces the wage deduction by $1,350. This prevents double-counting — the credit is generally more valuable than the deduction (depending on the employer's marginal tax rate), but the §280C(a) reduction must be factored into the net benefit calculation.

Employee Compensation Threshold: Employees with prior-year W-2 wages or net self-employment income above the inflation-adjusted threshold ($81,000 for the most recent published year) are excluded from the credit calculation. Verify the current threshold annually in the applicable IRS Rev. Proc.

Payroll Tax Mechanics

Employer PFML contributions are not wages and are not subject to FICA (Social Security and Medicare) or FUTA. They are paid to state agencies and flow to the income tax return as business expenses — Schedule C for sole proprietors, Form 1065 for partnerships, Form 1120-S for S-Corps, Form 1120 for C-Corps.

Employee PFML contributions withheld from wages require careful mechanics:

• FICA applies to the employee's gross wages before the PFML withholding is deducted. Employee PFML contributions are withheld after FICA is computed — meaning both the employer and employee pay FICA on the full gross wage, not on the net-of-PFML amount.
• The employer withholds, collects, and remits to the state fund. These withholdings appear on the employee's W-2, Box 14 ("Other"), labeled with the state program name (e.g., "NY PFL," "WA PFML," "MA PFML"). Box 14 is informational; employees who itemize can potentially claim the Box 14 amount as a state tax deduction on Schedule A, subject to the $10,000 SALT cap under IRC §164(b)(6).
• Employee PFML contributions are not Box 1 reductions — they do not lower federal taxable wages. They are withheld from the employee's take-home pay but remain in gross income for federal income tax purposes.

S-Corp shareholder owner-employees: Shareholders owning 2% or more are excluded from certain employee benefit exclusions under IRC §1372, but state PFML program participation rules vary independently of IRC §1372. Several states — including New York, Colorado, and Washington — permit majority shareholders (typically those owning 50% or more) to opt out of PFML participation. Others require participation regardless of ownership level. There is no blanket federal exclusion. CPAs should review each applicable state's opt-out rules annually — several states have narrowed owner opt-out rights in recent cycles. For the underlying employee/contractor classification framework that determines who qualifies as an employee for PFML purposes, see How to Classify Workers as Employees or Independent Contractors Under IRS Rules.

Taxation of PFML Benefits Received

The federal tax treatment of benefits employees receive depends on the funding source:

Employer-paid benefits (voluntary or private plan): Benefits paid directly by the employer are wages for federal income tax purposes. They are subject to federal income tax withholding, FICA (both employee and employer shares), and FUTA. The employer includes these payments in Box 1 of the employee's W-2.

State fund benefits — employee-funded programs (CA, NJ, CT, RI): Benefits are taxable under IRC §61 as ordinary income but are not wages for FICA purposes. FICA does not apply to state fund payments because the employer is not making a wage payment. The state fund issues a Form 1099-G or equivalent state document. Employees include the amount in gross income; no FICA withholding applies.

State fund benefits — split-funded programs (MA, WA, OR, CO, DC, MD, MN): The benefit paid to the employee is a mix of employer-contribution-funded and employee-contribution-funded dollars. Under IRS Notice 2020-54, the portion attributable to employer contributions is taxable as wages; the portion attributable to employee after-tax contributions is a tax-free return of previously taxed basis. In practice, most state funds issue a single aggregate payment and do not break out the allocation — CPAs should apply the allocation methodology in Notice 2020-54 using the contribution ratios for the benefit year.

State conformity: Several states exempt their own PFML benefits from state income tax even when they are federally taxable. Notable examples:

CPAs preparing returns for employees who received PFML benefits must apply both federal and state rules — the 1099-G amount is often the federal gross taxable amount, not the state taxable amount, and state returns may require a subtraction adjustment.

If an S-Corp shareholder or pass-through business owner has a PFML leave year that shifts their estimated tax position — particularly if state fund benefits received are taxable income not subject to withholding — update their quarterly estimated tax schedule accordingly. See How to Calculate and File Quarterly Estimated Taxes for Business Clients for the safe-harbor calculation mechanics.

Written Policy Requirements and Documentation

The §45S written policy is not a mere formality — it is a statutory element, and the IRS will request it in an examination of a credit claim. The policy must:

• Identify the leave reasons that qualify (FMLA-qualifying reasons)
• State the minimum leave duration (at least two weeks annually)
• State the wage replacement rate (at least 50% of normal wages)
• Cover all qualifying employees without restricting eligibility beyond the 12-month service requirement
• Be dated and in effect before the leave period for which the credit is claimed

The IRS has not mandated a particular format. A signed, dated payroll policy document, employee handbook section, or standalone paid leave policy all satisfy the requirement. Employers must retain a copy of the policy as it existed during each credit year — the policy may be amended annually, but the version applicable to each leave event must be provable. Retroactive policy creation is not permitted; the credit is lost for leave events that preceded a valid written policy. For document retention standards applicable to tax credit support documentation, see How to Establish Document Retention Requirements for Business Clients.

Return Reporting for the §45S Credit

The §45S credit is claimed on Form 8994, Employer Credit for Paid Family and Medical Leave, filed with the employer's income tax return.

• C-Corps and S-Corps: Form 8994 attaches to Form 1120 or 1120-S. For S-Corps, the credit passes through to shareholders via Schedule K-1, Box 13, Code P.
• Partnerships: The credit passes through via Schedule K-1, Box 15, Code P.
• Sole proprietors: Form 8994 attaches to Form 1040; the credit flows through Form 3800 (General Business Credit).
• General Business Credit: The §45S credit is a component of the general business credit on Form 3800. It is nonrefundable but unused amounts carry back one year and carry forward 20 years (IRC §39).
• Wage deduction adjustment: The deductible wages on the return must be reduced by the §45S credit amount. Failure to make this §280C(a) adjustment is a common exam finding.

PFML and ACA Employer Mandate Coordination

Employees on FMLA leave — whether paid or unpaid — retain the right to continued group health coverage under the FMLA's benefits-continuation rules (29 CFR §825.209). For applicable large employers subject to the ACA's employer shared responsibility provisions under IRC §4980H, coverage must be maintained or offered during leave periods in the same manner as during active employment. An employer that drops health coverage during a paid PFML period faces the same §4980H(b) exposure as dropping coverage during any other absence. The interaction between PFML leave administration and ACA compliance is a frequent gap in employer policies — CPAs who identify this coordination issue and flag it to the employer's benefits broker add meaningful value. For a complete breakdown of ACA employer mandate mechanics, see ACA Employer Mandate: The 50-Employee Threshold, Coverage Requirements, and Penalties Explained. For the benefits broker's perspective on coordinating PFML with private STD and LTD programs — including integration vs. supplementation models, elimination period alignment, and voluntary plan options — see PFML and Private Disability Coordination: How Brokers Should Structure STD/LTD Benefits in States with Mandatory Leave Programs.

Frequently Asked Questions

Are mandatory state PFML employer contributions deductible?

Yes. Mandatory state PFML employer contributions are deductible as ordinary and necessary business expenses under IRC §162. They are not wages, are not subject to FICA or FUTA, and are reported as payroll taxes or state program premiums on the employer's federal return. Programs in Massachusetts, Washington, Oregon, Colorado, DC, Maryland, Minnesota, and Delaware all require employer contributions; programs in California, New Jersey, Connecticut, New York, and Rhode Island are employee-funded only, so those employers have no PFML employer contribution to deduct (though they still withhold employee contributions and may have SDI-related obligations).

Can an employer deduct both the wages paid during leave and claim the §45S credit?

No — not for the same dollar amount. IRC §280C(a) requires the employer to reduce the wage deduction by the amount of §45S credit claimed. The credit and the deduction cannot both apply to the same wages. The net tax benefit still favors claiming the credit (a credit reduces tax dollar-for-dollar, while a deduction only reduces tax by the marginal rate), but the §280C(a) reduction must be included in any cost-benefit analysis.

What counts as "wages paid during leave" for §45S?

Only wages the employer directly pays the employee during a qualifying leave period count. State fund payments made directly to the employee by the state program do not count — even if the employer remitted the state contributions that funded those payments. If an employer supplements state fund payments (e.g., the state pays 60% and the employer tops up to 100% of normal wages), only the employer's top-up portion generates the §45S credit.

Do employees owe FICA on state PFML benefits they receive from the state fund?

No. State fund payments are not wages for FICA purposes and are not subject to Social Security or Medicare taxes. They are taxable as ordinary income under IRC §61, but FICA withholding does not apply because the state — not the employer — is making the payment. FICA applies only when the employer itself pays wages during leave under a voluntary or private PFML arrangement.

Are S-Corp owner-employees excluded from state PFML programs?

It depends on the state. Several states permit majority shareholders to opt out; others require all W-2 employees to participate regardless of ownership percentage. New York, Colorado, and Washington have formal opt-out mechanisms for owners meeting specified ownership thresholds. There is no federal exclusion analogous to the §106 group health exclusion that would automatically exempt owner-employees. CPAs should review applicable state rules before filing and check annually — state legislatures have been narrowing opt-out rights as programs expand.

How are employee PFML contributions shown on the W-2?

Employee PFML contributions withheld from wages appear in Box 14 ("Other") of the W-2, labeled with the applicable state program name. They are not included in Box 1, Box 3 (Social Security wages), or Box 5 (Medicare wages) as reductions — gross wages are the basis for FICA. Box 14 is informational and allows employees who itemize to identify the amounts for a potential Schedule A SALT deduction, subject to the $10,000 cap under IRC §164(b)(6).

What happens if the employer paid FMLA leave but had no written policy at the time?

The §45S credit is not available without a written policy that met all statutory requirements before the leave began. Ad hoc leave payments — even at 50%+ wage replacement for FMLA-qualifying reasons — do not qualify retroactively. The IRS will deny the credit on examination if the employer cannot produce a policy pre-dating the leave event. Employers in this situation should establish a compliant written policy immediately so that future leave events generate credits going forward.

Arvori helps CPAs and insurance brokers who advise the same small business clients coordinate on compliance issues at the intersection of tax and employee benefits. If your practice is navigating multi-state PFML obligations or helping employer clients evaluate voluntary paid leave programs alongside their group benefit designs, Arvori connects the advisory workflow so nothing falls through the gap between your services.