Tax Treatment Of Medical Family Leave Programs — Refund Opportunity

Mandatory State Paid Family and Medical Leave Programs and Federal Tax Clarification

The implementation of mandatory state paid family and medical leave (PFML) programs has introduced a wave of confusion regarding federal tax implications. In response to this confusion, nine governors jointly signed a letter to the IRS in January 2024, seeking much-needed clarification and guidance. The IRS addressed these concerns through Revenue Ruling 2025-4, which has since been the subject of extensive discussion. However, amidst the coverage, an important opportunity for refunds has emerged, which necessitates prompt action from eligible individuals. This summary delves into the key points of the ruling, the tax implications, and the potential refund opportunity.

Background: State Paid Family and Medical Leave Programs

As of now, thirteen states and the District of Columbia have implemented mandatory PFML programs, each with its own set of rules and structures. The ruling uses "State X" as a representative example, where the program pays workers taking leave for "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." In State X, all in-state employers and employees are required to contribute to the PFML Fund. The contribution rate is set at 1%, with employers and employees each responsible for a portion of this rate.

Employers in State X can withhold up to 0.6% of an employee’s wages for their contribution, while the employer is required to contribute 0.4% from its own funds. Employers have the flexibility to withhold a lesser amount—or even nothing at all—which would result in the employer paying a larger share. Importantly, the employer’s contribution is not included in the employee’s wages for the purpose of determining the required contribution. Additionally, employers have the option to establish a private insurance plan that provides the same benefits without additional cost to the employee. Benefits under the plan can amount to 80% of the employee’s wages for a maximum of 12 weeks if certain conditions are met.

Tax Issues: Employer and Employee Contributions and Benefits

The tax implications of PFML contributions and benefits are complex and have been a source of confusion. As expected, employer contributions to the PFML program are deductible against ordinary income as an excise tax. Importantly, these contributions are not included in the employee’s wages. Similarly, employee contributions withheld from their wages do not reduce their wage income. However, employees can deduct the amount withheld as a state income tax deduction if they itemize their deductions, subject to the existing limitations on state and local tax deductions.

The treatment of employer pick-up of employee contributions is more convoluted. While these contributions are deductible by the employer, they must be included in the employee’s gross income as wages. However, the employee can also deduct the amount as an itemized deduction, subject to the same state and local tax deduction limits. This rule is set to be enforced prospectively, allowing employers and payroll systems time to adjust.

The tax treatment of benefits under PFML programs varies depending on the type of leave. Family leave benefits are considered taxable income to the employee, but they are not treated as wages for FICA or Medicare tax purposes. On the other hand, medical leave benefits are typically treated as taxable wages to the extent they are attributable to the employer’s contribution. If medical leave benefits are used to reimburse out-of-pocket medical expenses, they may not be taxable, though this scenario is likely uncommon.

Refund Opportunity: Exclusion of Certain Medical Leave Benefits

The IRS ruling also brings some welcome news for individuals who have received medical leave benefits. According to the ruling, medical leave benefits attributable to employee contributions and employer pick-up are excluded from the employee’s federal gross income. This means that taxpayers who reported these benefits as taxable income in prior years may be eligible for a refund.

For instance, if an individual received medical leave benefits in 2021, 2022, or 2023 and reported the full amount as taxable income, they may now be able to amend their tax return to exclude the portion of the benefits attributable to their own contributions (and any employer pick-up). This could result in a refund of the taxes paid on that income. The opportunity to claim a refund is particularly significant for individuals in states where the employer pick-up is the primary source of funding, such as State X, where 60% of the contribution may be attributable to the employer.

Who Should Be Seeking a Refund?

Individuals who received medical leave benefits for their own health issues (not for family care) and reported the full amount as taxable income should strongly consider seeking a refund. The eligibility for a refund depends on the statute of limitations for amending a tax return. Generally, a refund claim must be filed within three years from the date the original return was filed or two years from the date the tax was paid, whichever is later. For example, if a taxpayer filed their 2021 return on time, they have until April 15, 2025, to amend their return and claim a refund.

For those who received medical leave benefits in 2021, it is especially urgent to act soon, as the window for amending the 2021 return is closing quickly. Tax preparers are likely to be busiest as the filing deadline approaches, so individuals should reach out to their tax professionals now to discuss amending their 2021 return. Those who received benefits in 2022 or 2023 can afford to wait until May or June before contacting their tax preparers, but they should not delay beyond that point. The process of amending a return to claim a refund is relatively straightforward, especially with the assistance of a tax professional and the right software, provided the original return was prepared on the same platform.

Effective Date of the Ruling and Transition Period

The Revenue Ruling 2025-4 is effective as of January 1, 2025, with a transition period for certain provisions. This effective date is particularly relevant for employers and payroll companies responsible for withholding and reporting under state PFML programs. However, the effective date does not preclude individuals from seeking refunds for prior years. The ruling is not a change in the law but rather a clarification of how existing rules apply to PFML programs. The confusion surrounding the tax treatment of PFML benefits existed long before the ruling, as evidenced by the governors’ request for clarification in early 2024.

In 2021 and 2022, when many taxpayers filed their returns, the tax treatment of PFML benefits was unclear. Now that the IRS has provided guidance, eligible individuals should take advantage of the opportunity to amend their returns and claim any refunds they are owed. This is not about taking advantage of a loophole or exploiting ambiguity; it is about ensuring that taxpayers are not unfairly subjected to taxes on income that is now understood to be excludable under federal law.

Conclusion: Understanding the Ruling and Taking Action

Revenue Ruling 2025-4 provides long-awaited clarity on the federal tax implications of mandatory state paid family and medical leave programs. While the ruling addresses a range of issues, including the deductibility of employer contributions and the tax treatment of benefits, one of the most important takeaways is the opportunity for refunds for eligible individuals. For those who received medical leave benefits funded by employee contributions or employer pick-up and reported those benefits as taxable income, amending prior returns could result in a significant refund.

The urgency of this opportunity varies depending on the year in which the benefits were received. For 2021 benefits, the window for amending the return is rapidly closing, making it critical to act soon. For 2022 and 2023 benefits, there is more time, but individuals should still plan to take action well before the filing deadlines to avoid missing out on potential refunds. Tax professionals will play a crucial role in helping individuals navigate the amendment process, and individuals are encouraged to reach out to their tax preparers sooner rather than later to ensure they do not miss this valuable opportunity.

Acknowledgement

The author would like to extend gratitude to Jeff Kristoff, CPA, Director of Tax at Rosen & Associates LLP, for bringing this important refund opportunity to their attention.