April 7, 2020
The Internal Revenue Service (IRS) has issued FAQs (opens a new window) that explain the tax credits available to employers that provide mandated paid sick leave and expanded Family Medical Leave Act (FMLA+) leave to their workers under the Families First Coronavirus Response Act (FFCRA). The FFCRA requires employers with fewer than 500 employees to provide paid sick leave and FMLA+ leave (collectively, qualified leave) to their workers for reasons related to COVID-19 beginning on April 1, 2020, through Dec. 31, 2020. Leave is capped at 10 days for sick pay and 10 weeks for FMLA+.
Lockton comment: Other requirements apply to the leave mandates, which are discussed in our recent alert (opens a new window) on the paid leave requirements, and in a companion alert (opens a new window) addressing a Department of Labor temporary regulation related to the leave mandates, issued the same day the IRS issued its FAQs.
The IRS has waded into the leave mandates because the employer’s cost of providing qualified leave wages is offset by refundable tax credits taken on its quarterly payroll tax returns. IRS has now explained the mechanics for how employers can claim the credits and what associated documentation is required.
Payroll taxes 101
Before we address the mechanics of the payroll tax credits, let’s touch on how federal payroll taxes (FICA) operate for most employers. Typically, both the employees and their employers are required to pay a 6.2% Social Security tax on an employee’s wages up to the taxable wage base of $137,700 (for 2020, as indexed). This is often referred to as “OASDI.” In addition, a 1.45% tax applies on wages to help fund hospital insurance under Medicare (called the HI tax), where there is no wage cap. The employee’s share of the taxes is withheld from wages.
Employers are required to remit payroll taxes either monthly or semiweekly and make a quarterly reconciliation filing with the IRS, generally using Form 941, Employer's Quarterly Federal Tax Return. Under its longstanding rules, the IRS strictly prohibits an employer from borrowing against its payroll tax obligation, and hefty fines can apply for not timely depositing the money with IRS.
Lockton comment: Under the FFCRA the employer does not owe its share of OASDI on qualified leave wages, but it owes the 1.45% HI tax and must withhold the employee share of OASDI, along with HI tax and federal income taxes. This distinction – that the employer owes no OASDI tax on qualified leave wages – will be important when we discuss how the employer claims tax credits on the qualified leave wages it pays.
What is included in the employer’s payroll tax credit?
While the law requires employers to provide sick leave and FMLA+ leave to their employees, Congress intended those costs to be fully offset by credits that are available to the employer when it submits its payroll taxes. Better yet, the tax credits are refundable (meaning the employer receives cash from the federal government if the tax credits are greater than the employer’s payroll tax obligations).
The credit amounts include:
Wage payments to employees for paid sick leave.
Wage payments to employees for paid FMLA+ leave.
The employer’s 1.45% HI tax related to the wage payments in 1 and 2 (the employer does not pay its OASDI tax on 1 and 2).
“Qualified health plan expenses” related to 1 and 2; see the discussion below.
Example: ABC Company pays $10,000 in sick leave wages and FMLA+ leave wages in the second calendar quarter of 2020. It does not owe the employer’s share of OASDI tax on the $10,000, but it will owe $145 for the employer’s share of the HI tax. ABC’s accrued tax credit equals $10,145, which includes the $10,000 in qualified leave wages plus $145 for ABC’s share of the HI tax on those wages.
This amount may be applied against any federal employment taxes ABC is liable for on any wages (including wages paid to employees who are not on qualified leave) paid in the second calendar quarter of 2020. Any excess over the federal employment tax liabilities is refunded in accordance with normal procedures. ABC must still withhold the employee’s share of OASDI and HI taxes on the qualified leave wages paid, but rather than remit those dollars to the IRS, ABC applies that amount against the credit it is due.
Calculating qualified health plan expenses as part of the tax credit
Employers who provide health coverage during sick leave and expanded FMLA leave are eligible to include them in the calculation of the tax credit to help them offset those costs. These costs include the employer subsidy for health insurance plus any employee pretax contributions under Section 125 (but not employee after-tax payments). Qualified health plan expenses also include employer contributions to health FSAs and health reimbursement arrangements, but not small-employer HRAs (known as QSEHRAs) or employer contributions to health savings accounts (HSAs).
Lockton comment: The DOL has indicated employer health coverage must continue during mandated paid sick leave. An employee on FMLA+ leave qualifies for health coverage to the same extent as an active employee, under longstanding rules that apply to FMLA leaves.
The IRS requires the health insurance expenses be allocated to the sick leave or FMLA+ leave wages on a pro rata basis among covered employees (for example, the average premium for all employees covered by a plan) and pro rata on the basis of periods of coverage (relative to the time periods of leave to which such wages relate). If there are separate plans, the health plan expenses are determined separately for each plan. This methodology is further explained below, with an example.
For fully insured plans, the employer can use (1) the COBRA premium for the employee receiving the qualified leave wages, (2) the average premium rate for all employees receiving qualified leave wages, or (3) any substantially similar method that takes into account the average premium rate determined separately for employees with self-only and other than self-only coverage.
If the employer chooses to use the average premium rate for all employees (option 2 above), the allocable amount for each day an employee covered by the health plan is entitled to qualified leave wages could be determined using the following steps:
The employer’s overall annual premium for the employees covered by the policy is divided by the number of employees covered by the policy to determine the average annual premium per employee.
This average annual premium per employee is divided by the average number of workdays during the year by all covered employees (treating days of paid leave as a workday and a workday as including any day on which work is performed) to determine the average daily premium per employee. For example, a full-year employee working five days per week may be treated as working 52 weeks x 5 days or 260 days. Calculations for part-time and seasonal employees who participate in the plan should be adjusted as appropriate. Employers may use any reasonable method for calculating part-time employee workdays.
The resulting amount is the allocable amount for each day of qualified sick or family leave wages, and that amount becomes part of the tax credit due to the employer, in addition to the amount of the qualified leave wages paid to employees.
Example: ABC Company sponsors an insured group health plan that covers 400 employees, some with employee-only coverage and some with family coverage. Each employee is expected to have 260 workdays a year. (Five days a week for 52 weeks.) The employees contribute a portion of their premium on a pretax basis under a Section 125 plan, with different amounts for self-only and family coverage. The total annual premium for the 400 employees is $5.2 million. This includes both the amount paid by ABC and the amounts paid pretax by employees.
If ABC uses one average premium rate for all employees, the average annual premium rate is $5.2 million divided by 400, or $13,000. For each employee expected to have 260 workdays a year, this results in a daily average premium rate equal to $13,000 divided by 260, or $50. That $50 is the amount of qualified health expenses allocated to each day of paid sick or FMLA+ leave per employee.
For self-funded plans, the employer can use (1) the COBRA premium for the employee receiving the qualified leave wages, or (2) any reasonable actuarial method to determine the estimated annual expenses of the plan (here, rules similar to the rules for insured plans are used to determine the amount of expenses allocated to an employee).
Claiming the credits
Employers claim their tax credits for wage payments for sick leave and FMLA+ leave (including the related HI taxes and qualified health insurance costs) each calendar quarter on their IRS Form 941.
Existing rules prohibit an employer from accessing withheld taxes and failing to deposit them on a timely basis. However, the IRS will allow employers to claim their tax credits for the sick leave pay and FMLA+ leave pay by offsetting those payments against their payroll tax and tax withholding liability for wages paid to all employees between April 1, 2020, and Dec. 31, 2020, amounts that would otherwise be required to be deposited with the IRS.
Example: ABC Company paid $5,000 in sick leave wages and FMLA+ leave wages (including health plan expenses and ABC’s share of HI tax on the qualified leave wages) and is otherwise required to deposit $8,000 in federal employment taxes. This includes taxes withheld from all its employees for wage payments made during the same quarter in which it paid the $5,000 in qualified leave wages. ABC may keep up to $5,000 of the $8,000 of taxes ABC was going to deposit. ABC is then only required to deposit the remaining $3,000 on its required deposit date. ABC will later account for the $5,000 it retained when it files Form 941 for the quarter.
The IRS will modify the Form 941 to reflect the reduced liabilities associated with this advance funding. If an employer does not have enough employment taxes set aside, it can request an advance of the credits by completing an IRS Form 7200 (Advance Payment of Employer Credits Due to COVID-19).
Employer substantiation and documentation requirements
Because the employer may claim a tax credit for the amount of qualified leave payments made to employees, the IRS requires the employer to obtain information from the employee to substantiate the bona fide need for the leave.
This written request should include:
The employee’s name
The date or dates for which leave is requested
A statement of the coronavirus-related reason the employee is requesting leave and written support for such reason, and
A statement that the employee is unable to work, including by means of telework, for such reason.
In the case of a leave based on a quarantine order or self-quarantine advice, the statement from the employee should include:
The name of the governmental entity ordering quarantine or the name of the healthcare professional advising self-quarantine, and
If the person subject to quarantine or advised to self-quarantine is not the employee, that person’s name and relation to the employee.
In the case of a leave request based on a school closing or child care provider unavailability (FMLA+), the statement from the employee should include:
The name and age of the child (or children) to be cared for,
The name of the school that has closed or place of care that is unavailable, and
A representation that no other person will be providing care for the child during the period for which the employee is receiving family medical leave and, with respect to the employee’s inability to work or telework because of a need to provide care for a child older than fourteen during daylight hours, a statement that special circumstances exist requiring the employee to provide care. Note: This includes the individual’s spouse.
Lockton comment: The IRS guidance does not require third-party substantiation (such as a physician’s note regarding the illness or a letter or email from the school or child care facility noting its closure) to obtain the IRS tax credits. Therefore, there is no obligation on the part of the employer to demand substantiation. Employers concerned about maintaining their workforces to meet maximum operating needs might determine third-party substantiation is required pursuant to the employer’s policy. But such substantiation is not required for purposes of claiming the credit.
The employer must also maintain books and records that show:
How the employer determined the amount of sick and family leave wages paid to employees who are eligible for the credit, including records of work, telework and qualified leave.
How the employer determined the amount of qualified health plan expenses that the employer allocated to wages.
Copies of any completed Forms 7200, Advance of Employer Credits Due To COVID-19, that the employer submitted to the IRS.
Copies of the completed Forms 941, Employer’s Quarterly Federal Tax Return, that the employer submitted to the IRS).
The IRS instructs that employers should keep these records for at least four years after the taxes are due, in the event of an IRS audit.
Other issues
Employees are able to make pretax Section 125 contributions from their qualified leave payments.
Any wages claimed for tax credits cannot also be claimed under the employee retention credit under the CARES Act (that is, no “double dip”).
The tax credits can be claimed by the self-employed (such as a partner in a partnership or a more than 2% shareholder in a S-corporation).
Special rules apply if an employer uses a third party, such as a professional employer organization (PEO), to pay and report employment taxes.
Tax-exempt employers can receive the tax credits, but not governmental employers.
The tax credits received by an employer are subject to income tax.
Conclusion
Employers will need to carefully study the new rules and discuss the mechanics of the tax credits with their payroll vendor. Note that the credits are only available to employers with fewer than 500 employees and only with respect to leaves taken from April 1, 2020, through Dec. 31, 2020. Note, too, that when counting employees an employer might need to aggregate its employee count with that of an entity considered “integrated” with the employer, as we have explained in our prior alerts.
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 are not privileged under the attorney-client privilege.
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