Federal Tax Treatment and Reporting of State PFML Benefits – IRS Extends Compliance Deadline to 2027

Over the last decade, more than a dozen states have established state-run mandatory paid family and medical leave (PFML) programs, including California, Massachusetts, New York, and Maine. These programs generally require employers and employees to pay into a state fund, unless an exemption applies, and when an employee goes on qualified leave, benefits are paid directly to the employee by the state.

In Maine, the state PFML program began accepting required contributions last year, and employees may begin receiving benefits from the state this May. As employers in Maine and other states with PFML programs implement administrative policies to navigate program compliance, questions arise about the federal tax treatment of contributions to the program and benefits paid by the state, as well as whether and how employers are required to report contributions and benefits to the IRS.

In January 2025, the IRS issued Rev. Rul. 2025-4, which outlines the federal income tax withholding and reporting obligations for employers with respect to state-run PFML programs. Employers were required to comply with most aspects of Rev. Rul. 2025-4 beginning with contributions and benefits paid in calendar year 2026. But in December 2025, the IRS issued Notice 2026-6, delaying the compliance deadline until 2027 for some of the most complicated aspects of Rev. Rul. 2025-4. As described in more detail below, the extension applies to withholding and reporting obligations in connection with medical leave benefits paid by a state that are attributable to employer contributions.

But 2027 will be here soon enough, and employers should use this year to implement procedures to ensure a smooth transition to compliance with all aspects of Rev. Rul. 2025-5. Below is an overview of the federal income tax withholding and reporting requirements that apply to contributions and benefits in state-run PFML programs.

Contributions to state PFML programs

Generally, state PFML programs require both employers and employees to make contributions to the program. Employers are typically free to pay some or all of the employee portion of contributions. Any amounts paid by employees are withheld from employee pay and remitted to the state, along with employer contributions.

The following withholding and reporting requirements apply to contributions:

• Mandatory employer contributions are treated as employer payments of state income tax. These amounts are not included in the employee’s federal taxable income or reported on Form W-2. The employer may deduct these amounts as taxes incurred in carrying on a trade or business.
• Employee contributions that the employer withholds from an employee’s pay are treated as the employee’s payment of state income tax. These amounts are treated as wages and included in the employee’s federal taxable income, and the employer must report them on Form W-2. Employees may deduct these amounts on their federal tax returns to the same extent as other state and local taxes.
• If an employer voluntarily pays some or all of the employee’s portion of contributions, the voluntary employer contributions are treated as taxable wages to the employee, and the employer must report these amounts on Form W-2. These amounts are deductible by the employer as a business expense. Employees may deduct these amounts on their federal tax returns to the same extent as other state and local taxes.

PFML benefits paid to employees by a state

When an employee goes on leave and receives benefit payments from a state PFML program, the federal income tax treatment of those payments depends on whether the payments are classified as family leave or medical leave.[1]

Family leave – Family leave payments received from the state are taxable income to the employee. These payments, however, are not treated as wages for federal income tax purposes, and the employer has no responsibility to withhold income tax from them or report them to the IRS. Instead, the state is required to report these payments on Form 1099.

Medical leave – The federal tax treatment of medical leave payments received from the state depends on whether the payments are “attributable” to employee contributions or employer contributions. When medical leave benefits are paid, the portions of the payment attributable to employee and employer contributions are based on the portions of the contributions that were paid by the employee and the employer. Employers may be familiar with this distinction as it applies to disability payments and similar welfare benefits.

Medical leave payments received from the state are taxed as follows:

• Medical leave payments attributable to employee contributions (or attributable to the employer’s voluntary payment of the employee portion of contributions) are not treated as wages and are excluded from the employee’s taxable income. The payments are not subject to employment taxes, and the employer is not required to withhold from these payments or report them to the IRS.
• Medical leave payments attributable to the employer’s mandatory portion of contributions are treated as third-party payments of sick pay. Under IRS regulations applicable to third-party payments of sick pay, the third-party payor (not the employer) is generally responsible for employment taxes on third-party payments of sick pay, any required income tax withholding, and reporting the payments on Form W-2 as if the payor were the employer. But depending on the terms of the relationship between the payor and the employer, that responsibility may shift back to the employer. Guidance from individual states may be needed to determine how these rules will apply to PFML benefits.
  

  Pursuant to Notice 2026-6 discussed above, compliance with withholding, reporting, and employment tax requirements is not required for payments of medical leave attributable to the employer’s mandatory portion of contributions made in calendar year 2026. The transition period was granted to give employers and states more time to establish procedures for the coordinated reporting process that is required for these payments. Employers should use this year to ensure they understand how their state will handle IRS reporting and employment tax obligations with respect to medical leave payments.

Effect on retirement plans and other benefits

In addition to implementing administrative processes to ensure correct withholding and IRS reporting, employers should also consider how benefits paid under a state PFML program may affect retirement plan contributions and other employer benefit plans.

For example, retirement plan contributions may be determined as a percentage of an employee’s “compensation.” Although not common, depending on the plan’s definition of compensation, it is possible that some payments received by an employee through a state PFML program could fall under that definition. In many cases, that would present a significant administrative hurdle for the employer. Employers should work with their retirement plan advisors to confirm their plans’ definitions of compensation and consider whether an amendment specifically addressing the treatment of state PFML benefits is appropriate.

If you have questions about compliance with state PFML programs and the associated federal tax rules, please contact a member of Verrill’s Employee Benefits & Executive Compensation Group.

[1] This distinction may be complicated in situations such as childbirth, where an employee may receive both family and medical leave benefits during the same period of leave. The administrative complexity for employers may depend on the quality of reporting they receive from the state, but employers are encouraged to consult counsel for advice on navigating specific situations.