IRS Provides Guidance on Employer Credit for Paid Family and Medical Leave Under Section 45S

Executive Summary

The Internal Revenue Bulletin for August 17, 2026, introduces critical updates to the Employer Credit for Paid Family and Medical Leave under Section 45S of the Internal Revenue Code, as amended by the One, Big, Beautiful Bill Act (OBBBA, Pub. L. 119-21, 139 Stat. 72, July 4, 2025). This legislation permanently extends Section 45S and introduces sweeping changes to its administration, including a premium method for calculating the credit and revised aggregation rules. The IRS’s issuance of Notice 2026-28 and Announcement 2026-14 provides comprehensive guidance on these amendments.

Key changes include:

• Permanent extension of Section 45S, replacing its prior temporary status.
• Introduction of a premium method for credit calculation, alongside the traditional wage method.
• Revised aggregation rules aligning with Section 414(b) and (c).
• Updated form measurement standards for tax practitioners.

The permanence of Section 45S reflects Congress’s recognition of the credit’s role in incentivizing employers to adopt paid leave policies. The OBBBA’s amendments expand eligibility criteria, refine calculation methods, and clarify compliance requirements. For tax practitioners, these updates necessitate immediate review of employer policies, payroll systems, and documentation practices.

The credit ranges from 12.5% to 25% of wages, scaled based on the employer’s wage replacement rate. The premium method allows employers to claim the credit based on insurance premiums paid for qualifying leave insurance policies. For employers, the choice between the wage method and premium method hinges on cost-benefit analysis, administrative capacity, and state-specific leave mandates.

The IRS’s correction to Rev. Proc. 2026-18 via Announcement 2026-14 standardizes form measurements to ensure consistency across information return filings. The IRS’s request for public comments on Notice 2026-28 signals ongoing evolution in guidance.

For employers, immediate action items include auditing existing leave policies, updating payroll systems, and consulting tax advisors on deduction strategies. The IRS’s enforcement posture suggests increased scrutiny of Section 45S claims.

Deep Dive: Guidance on the Employer Credit for Paid Family and Medical Leave Under Section 45S

The permanence of Section 45S under the One, Big, Beautiful Bill Act (OBBBA) transforms it from a temporary measure into a permanent fixture of employer-sponsored leave programs. The IRS’s issuance of Notice 2026-28 reflects this shift, embedding the credit’s permanence into employer tax planning.

Legislative History and Amendments

Enacted as part of the Tax Cuts and Jobs Act (TCJA) in December 2017, Section 45S was originally a two-year pilot program. Its termination date was extended three times before the OBBBA (Pub. L. 119-21, enacted July 4, 2025) made the credit permanent. This evolution reflects bipartisan recognition of the credit’s value in supporting work-life balance and workforce retention.

Key Amendments

The OBBBA introduced significant amendments to Section 45S, including:

• A premium method for calculating the credit, alongside the traditional wage method.
• Clarification that the premium method decouples the credit from actual leave disbursements, enabling employers to claim the credit even if no employees take leave during a taxable year.
• Removal of ambiguity regarding the rate of payment under the premium method.

The aggregation rule under Section 45S(c)(3) underwent a critical shift in the One, Big, Beautiful Bill Act (OBBBA, Pub. L. 119-21, 139 Stat. 72 (July 4, 2025)), replacing the prior reliance on Section 52(a) or (b) with the Section 414(b) and (c) framework. This change aligns the aggregation rules for the Employer Credit for Paid Family and Medical Leave with those used for retirement plans and employee benefit programs.

The shift to Section 414(b) and (c) means that employers must now determine whether they are part of a controlled group or affiliated service group based on the 80% ownership test (for parent-subsidiary relationships) or common control/service relationships (for affiliated service groups). This departs from the prior Section 52(a) or (b) standard, which focused on parent-subsidiary and brother-sister relationships with broader ownership thresholds.

Aggregation Rules and Exceptions

The aggregation rule under Section 45S(c)(3) requires that all entities within a controlled group or affiliated service group be treated as a single employer for Section 45S purposes. This means leave policies, wage calculations, and credit claims must be evaluated collectively.

The Exception

An exception permits employers to avoid aggregation if they can demonstrate a "substantial and legitimate business reason" for failing to provide a written policy satisfying Section 45S(c)(1) or (c)(2). The statute does not define this phrase, and the IRS has requested comments on what constitutes such a reason. Employers should document any business reasons for noncompliance, such as operational constraints or industry-specific challenges. However, the IRS’s historical stance on anti-discrimination rules suggests it will reject exceptions that appear to favor highly compensated employees.

Retroactive Application

The aggregation rule applies retroactively to taxable years beginning after December 31, 2025. Employers should review prior tax filings to ensure aggregation was applied correctly and amend filings if necessary.

Implications for Multi-State Employers

Multi-state employers must evaluate whether their leave policies comply with Section 45S across all entities, even if some operate in states with mandated paid leave laws. State or local leave required by law does not count toward the credit, but employers must still ensure their written policies meet Section 45S(c)(1) or (c)(2) requirements for all employees within the aggregated group.

The shift to Section 414(b) and (c) for aggregation also aligns with broader trends in IRS enforcement and tax compliance, where the agency increasingly treats controlled groups and affiliated entities as a single taxpayer for various purposes. This alignment reduces the risk of tax arbitrage—where entities structure ownership to exploit loopholes—but it also increases the compliance burden for employers with complex structures. The IRS’s request for comments in Notice 2026-28 suggests that the agency is open to feedback on how to apply the aggregation rule in practice, particularly for small businesses and startups that may lack the resources to comply with the new requirements.

In summary, the changes to the aggregation rule under Section 45S(c)(3) represent a significant shift in how employers must evaluate eligibility for the Employer Credit for Paid Family and Medical Leave. The move from Section 52(a) or (b) to Section 414(b) and (c) introduces a more standardized framework but also increases the compliance burden for affiliated groups and controlled entities. The exception for "substantial and legitimate business reasons" remains ambiguous, and employers should proceed with caution when relying on it. The retroactive application of the rule means that immediate action is required to review and amend prior filings where necessary. Practitioners must advise their clients to conduct a thorough compliance review, document all business decisions, and anticipate further IRS guidance as the agency continues to refine its interpretation of the new aggregation rules.

Premium Method: Criteria for Creditable Coverage and Allocation Rules

The premium method allows employers to claim the credit based on insurance premiums paid for qualifying leave insurance policies. Unlike the wage method, which calculates the credit based on wages paid directly to employees during qualifying leave, the premium method hinges on whether the premium funds creditable coverage.

Creditable Coverage Criteria

Creditable coverage under the premium method is defined narrowly by the IRS as a premium that funds leave meeting the statutory definition of paid family and medical leave under Section 45S(e) and paid to a qualifying employee under Section 45S(d). A premium is not for creditable coverage if it funds:

• Leave required by state or local law.
• Leave paid for by a state or local government.
• Leave payable to an individual who is not a qualifying employee.
• Benefits that would not constitute wages under Section 45S(g).

Allocation of Blended Premiums

When an employer pays a blended premium—one that funds both creditable and noncreditable coverage—the IRS requires allocation using a reasonable method that is consistent with the policy terms and supported by contemporaneous records. The allocation method must be applied consistently for the taxable year and to all persons treated as a single employer under the aggregation rules of Section 45S(c)(3).

The IRS’s scrutiny of allocation methods is not theoretical; it is rooted in the statute’s requirement that the credit be calculated with precision and that employers substantiate their claims with verifiable data. The IRS’s guidance in Notice 2026-28 signals that employers using blended premiums must implement allocation systems that can withstand IRS review, particularly in industries where state-mandated leave or multi-tiered benefit structures are common. The IRS’s approach aligns with its broader enforcement strategy under the OBBBA, where the agency is increasingly targeting credits claimed without adequate documentation or with policies that do not meet the statutory requirements. The IRS’s guidance in Notice 2026-28 is consistent with its prior notices, such as Notice 2018-71, which emphasized the need for written policies and contemporaneous records to substantiate credit claims. The IRS’s focus on allocation rules for blended premiums is a direct response to the growing complexity of employer-provided leave programs, where employers often use insurance policies to fund a mix of qualifying and nonqualifying leave. The IRS’s guidance ensures that the premium method does not become a loophole for claiming credits on benefits that do not meet the statutory criteria. The IRS’s emphasis on contemporaneous records and objective criteria is not merely procedural; it is a safeguard against abuse and a means to ensure that the credit is claimed only for benefits that Congress intended to incentivize. The IRS’s guidance in Notice 2026-28 is a critical tool for practitioners navigating the premium method, as it provides the framework for structuring compliant leave programs and avoiding disallowance of the credit.

Electing Between the Premium and Wage Methods: Key Considerations for Employers

The IRS’s guidance in Notice 2026-28 outlines strict election rules for employers using the premium and wage methods under Section 45S.

Election Rules

Employers may elect the premium method for one employee’s leave while electing the wage method for another employee’s leave, provided each election is applied to distinct leave events. However, the same instance of leave cannot be claimed under both methods.

Prohibition on Double-Dipping

The IRS prohibits claiming both the premium and wage methods for the same leave. For example, if an employer claims the premium credit for a premium funding creditable coverage, the employer cannot claim the wage credit for wages paid to an employee during leave funded by that same premium.

Allocation of Mixed-Funded Leave

For leave partially funded by premiums and partially funded by the employer’s general assets, the employer may claim:

• The premium credit for the portion funded by the premium.
• The wage credit for the portion funded by the employer’s general assets.

This ensures the credit is claimed only for the portion of the leave directly subsidized by the employer’s outlay.

The implications for employers are significant. Structuring leave policies to take advantage of both methods requires careful planning to ensure compliance with the election rules. Employers must maintain detailed records to distinguish between leave funded by premiums and leave funded by general assets, as well as to document the allocation of credits between the two methods. The IRS’s guidance underscores the importance of segregating funding sources and avoiding overlap in credit claims, as failure to do so could result in disallowance of the credit and potential penalties. For practitioners, this means advising clients to implement robust tracking systems that can withstand IRS scrutiny, particularly in industries where leave policies may involve complex funding arrangements.

The election rules also highlight the broader policy considerations underlying Section 45S. The premium method and wage method serve different purposes: the premium method incentivizes employers to provide paid leave through group health plans, while the wage method incentivizes direct wage replacement. By allowing employers to elect between the two methods for different leave instances, the IRS provides flexibility while maintaining guardrails to prevent abuse. However, the prohibition on double-dipping for the same leave ensures that the credit remains a targeted incentive rather than a broad subsidy. For employers, this means carefully evaluating which method best aligns with their leave policies and funding structures, while ensuring compliance with the IRS’s allocation and election rules.

Aggregation Rules and Exceptions: What Employers Need to Know

The aggregation rule under Section 45S(c)(3) underwent a critical shift in the One, Big, Beautiful Bill Act (OBBBA, Pub. L. 119-21, 139 Stat. 72 (July 4, 2025)), replacing the prior reliance on Section 52(a) or (b)—which governed aggregation for controlled groups under the Consolidated Omnibus Budget Reconciliation Act (COBRA) and Employee Retirement Income Security Act (ERISA)—with the Section 414(b) and (c) framework. This change aligns the aggregation rules for the Employer Credit for Paid Family and Medical Leave with those used for retirement plans and employee benefit programs, creating a more standardized approach across federal tax and labor provisions. The IRS explicitly noted in Notice 2026-28 that this amendment was intended to "provide consistency in the application of aggregation rules across federal tax and labor provisions," reflecting a broader trend toward harmonizing compliance frameworks under the IRC and ERISA.

The shift to Section 414(b) and (c) means that employers must now determine whether they are part of a controlled group or affiliated service group based on the 80% ownership test (for parent-subsidiary relationships) or common control/service relationships (for affiliated service groups). This is a departure from the prior Section 52(a) or (b) standard, which focused on parent-subsidiary and brother-sister relationships with broader ownership thresholds. For example, under Section 52(b), a brother-sister controlled group required five or fewer individuals to own more than 50% of the voting power or value of two or more corporations, whereas Section 414(b) applies the 80% ownership test uniformly. The IRS acknowledged this change in the preamble to Notice 2026-28, stating that the amendment "reflects the broader application of Section 414(b) and (c) across federal tax and labor laws."

The exception to the aggregation rule under Section 45S(c)(3)—which permits employers to avoid aggregation if they can demonstrate a "substantial and legitimate business reason" for failing to provide a written policy satisfying Section 45S(c)(1) or (c)(2)—introduces a nuanced compliance challenge. The statute does not define "substantial and legitimate business reason," leaving the IRS and practitioners to interpret its scope. The Treasury Department and IRS specifically requested comments in Notice 2026-28 on what constitutes such a reason, signaling that this area will likely see further regulatory clarification. The IRS’s request for comments suggests that factors such as business size, industry norms, or operational constraints may be considered, but no formal guidance has been issued to date. Practitioners should anticipate that the IRS may scrutinize claims of this exception closely, particularly where the failure to provide a written policy appears to be systemic or discriminatory rather than circumstantial.

For affiliated groups and controlled groups, the aggregation rule under Section 45S(c)(3) now requires that all entities within the group be treated as a single employer for purposes of determining eligibility for the credit. This means that leave policies, wage calculations, and credit claims must be evaluated collectively rather than in isolation. The IRS emphasized in Notice 2026-28 that this aggregation rule applies retroactively to taxable years beginning after December 31, 2025, unless otherwise specified in forthcoming proposed regulations. The retroactive application underscores the importance of immediate compliance reviews for employers with multiple entities, as prior tax filings may need to be amended if the aggregation rule was not applied correctly. The IRS’s guidance in Notice 2026-28 states that taxpayers may rely on the notice for taxable years beginning after December 31, 2025, and before the issuance of proposed regulations, but the retroactive nature of the rule suggests that the IRS may challenge prior filings that did not account for aggregation.

The implications of these changes are particularly acute for multi-state employers and industries with complex ownership structures, such as healthcare, manufacturing, and professional services. For example, a healthcare system with multiple affiliated hospitals and clinics must now evaluate whether its leave policies comply with Section 45S across all entities, even if some entities operate in states with mandated paid leave laws. The IRS’s guidance in Notice 2026-28 clarifies that state or local leave required by law does not count toward the credit, but employers must still ensure that their written policies meet the Section 45S(c)(1) or (c)(2) requirements for all employees within the aggregated group. Failure to do so could result in the disallowance of the credit for the entire group, not just the noncompliant entity.

The exception for "substantial and legitimate business reasons" introduces a potential compliance loophole, but its application is far from clear. The IRS’s request for comments in Notice 2026-28 suggests that the agency is aware of the ambiguity and may issue further guidance. In the interim, employers should document any business reasons for noncompliance with the written policy requirement, such as operational constraints, industry-specific challenges, or temporary disruptions. However, the IRS’s historical stance on anti-discrimination rules under Section 45S—as outlined in Notice 2018-71 and subsequent guidance—indicates that the agency will likely reject exceptions that appear to favor highly compensated employees (HCEs) or otherwise undermine the credit’s intent. The IRS’s Chief Counsel Memorandum 202114020 emphasized that the credit is designed to incentivize broad-based paid leave policies, not to subsidize selective or discriminatory practices.

For practitioners, the aggregation rule changes necessitate a comprehensive review of leave policies, ownership structures, and compliance documentation. Employers must now treat affiliated entities as a single employer for Section 45S purposes, which may require coordinating leave policies across multiple entities to ensure uniformity. The IRS’s guidance in Notice 2026-28 underscores the need for consistent application of policies within the aggregated group, as arbitrary distinctions between entities could trigger IRS scrutiny. Additionally, the retroactive application of the rule means that employers should retroactively evaluate prior tax filings to determine if aggregation was applied correctly, particularly for taxable years beginning after December 31, 2025.

The shift to Section 414(b) and (c) for aggregation also aligns with broader trends in IRS enforcement and tax compliance, where the agency increasingly treats controlled groups and affiliated entities as a single taxpayer for various purposes. This alignment reduces the risk of tax arbitrage—where entities structure ownership to exploit loopholes—but it also increases the compliance burden for employers with complex structures. The IRS’s request for comments in Notice 2026-28 suggests that the agency is open to feedback on how to apply the aggregation rule in practice, particularly for small businesses and startups that may lack the resources to comply with the new requirements.

In summary, the changes to the aggregation rule under Section 45S(c)(3) represent a significant shift in how employers must evaluate eligibility for the Employer Credit for Paid Family and Medical Leave. The move from Section 52(a) or (b) to Section 414(b) and (c) introduces a more standardized framework but also increases the compliance burden for affiliated groups and controlled entities. The exception for "substantial and legitimate business reasons" remains ambiguous, and employers should proceed with caution when relying on it. The retroactive application of the rule means that immediate action is required to review and amend prior filings where necessary. Practitioners must advise their clients to conduct a thorough compliance review, document all business decisions, and anticipate further IRS guidance as the agency continues to refine its interpretation of the new aggregation rules.

Treatment of State or Local Leave: How the OBBBA Changes the Game

The OBBBA’s amendments to Section 45S(c)(4) alter how state or local leave policies interact with the Employer Credit for Paid Family and Medical Leave.

Key Changes

• Eligibility Assessment: State or local leave must be taken into account when determining whether an employer qualifies as an "eligible employer" under Section 45S(a)(1).
• Credit Calculation: State or local leave is excluded from the calculation of the credit amount under Section 45S(a).

Policy Rationale

The OBBBA’s amendments aim to remove disincentives for employers to comply with state or local leave laws while maintaining the integrity of the credit. This dual approach ensures employers providing leave beyond state minimums are not penalized for complying with local mandates.

The Implication: Practical Guidance for Employers

For practitioners advising employers, the OBBBA’s amendments to Section 45S(c)(4) necessitate a two-pronged compliance strategy: eligibility verification and credit calculation separation. Employers must first determine whether their state or local leave policies meet the amended eligibility thresholds under Section 45S(a)(1). This requires a careful review of written leave policies to ensure they provide leave for FMLA-qualifying reasons and do not discriminate in favor of highly compensated employees (HCEs), as required by Section 45S(c)(1).

The second step involves segregating state-mandated leave from voluntary leave when calculating the credit. The IRS’s guidance in Notice 2026-28 makes clear that while state-mandated leave counts toward eligibility, it cannot be used to generate the credit. For example, an employer in California with a policy providing 12 weeks of paid leave (6 weeks state-mandated + 6 weeks voluntary) would include the entire 12 weeks in determining eligibility but could only claim the credit on the 6 weeks of voluntary leave. The IRS provided an illustrative example in Q&A-6 of Notice 2026-28: "If an employer pays a premium for an insurance policy that covers both state-mandated leave and additional voluntary leave, the premium must be allocated between the two components using a reasonable method supported by contemporaneous records."

Employers operating in multiple jurisdictions face additional complexity. The aggregation rules under Section 45S(c)(3)—amended by the OBBBA to align with Section 414(b) and (c)—require that all entities treated as a single employer must coordinate their leave policies to ensure compliance. The IRS cautioned in Notice 2026-28 that employers must apply the aggregation rules consistently, noting: "An eligible employer must allocate the premium between the creditable coverage and the noncreditable coverage using any reasonable method that is consistent with the policy terms and supported by contemporaneous records." This means that a multi-state employer with a centralized leave policy must demonstrate that the policy complies with the most restrictive state law while still providing additional leave in jurisdictions with weaker mandates to qualify for the credit.

The deduction disallowance under Section 280C(a) further complicates the analysis. Employers claiming the credit for voluntary leave must reduce their wage deductions by the amount of the credit, even if the leave is partially funded by state-mandated programs. The IRS reiterated in Notice 2026-28 that the deduction disallowance applies to the entire credit amount, regardless of whether the leave is state-mandated or voluntary. Practitioners should advise clients to model the tax impact of claiming the credit versus forgoing it and deducting the full wages, particularly for pass-through entities where the credit’s value may be outweighed by the lost deduction.

Finally, the retroactive application of the OBBBA’s amendments requires employers to review prior filings where state-mandated leave was incorrectly excluded from eligibility determinations. The IRS’s guidance in Notice 2026-28 states that the amendments apply to taxable years beginning after December 31, 2025, but practitioners should anticipate that the IRS may challenge prior-year claims that did not account for the new rules. Employers should conduct a thorough compliance review, document all policy decisions, and be prepared to amend prior filings if necessary. The IRS’s request for comments on the application of Section 45S(c)(4) to state-administered leave programs suggests that further guidance is forthcoming, and practitioners should monitor developments closely.

Redefining Qualifying Employees: Shorter Employment Periods and Hourly Requirements

The OBBBA’s amendments to Section 45S(d) revise the definition of a "qualifying employee" for purposes of the Employer Credit for Paid Family and Medical Leave.

Key Changes

• Service Requirement: Employers may elect to reduce the minimum employment period from one year to six months.
• Hourly Requirement: Employees must be customarily employed for not less than 20 hours per week.

Compliance Obligations

Employers must:

• Audit their workforce to identify employees who now qualify under the six-month rule.
• Ensure written leave policies incorporate the new thresholds.
• Configure payroll systems to track service duration and customary hours accurately.

Credit Calculations

The interaction between the new service requirement and the wage limitation under FUTA Section 3306(b) complicates credit calculations. Practitioners must model the credit impact under both the six-month and one-year standards to determine the optimal election for their clients.

From a tax planning perspective, the expanded definition of qualifying employees may incentivize employers to restructure their leave policies to maximize the credit. For example, a retail chain with a high proportion of part-time workers could adopt a six-month service requirement and a written policy offering two weeks of paid leave to all qualifying employees, thereby capturing a larger credit base while maintaining workforce competitiveness. Conversely, employers in industries with high turnover or seasonal peaks may find the six-month election less advantageous if the administrative burden of tracking short-tenured employees outweighs the credit benefit.

Practitioners should also consider the deduction disallowance under Section 280C(a), which prohibits a deduction for the portion of wages equal to the credit claimed. With a broader pool of qualifying employees, the Section 280C(a) adjustment will grow commensurately, reducing the net benefit of the credit. Employers must therefore conduct a cost-benefit analysis comparing the credit’s value against the lost deduction, particularly for pass-through entities where owners may prefer the deduction if their marginal tax rate exceeds the effective credit rate. The IRS’s automated systems are increasingly flagging mismatches between credits claimed and wage deductions, making this analysis a compliance necessity.

The notice also signals the IRS’s intent to finalize proposed regulations that will codify the guidance in Notice 2026-28. The IRS explicitly states that the forthcoming regulations will apply prospectively to wages and premiums paid or incurred after their issuance, but taxpayers may rely on the notice’s guidance for taxable years beginning after December 31, 2025. This creates a compliance window where employers can adopt the notice’s rules immediately while awaiting formal regulations. The IRS’s request for comments on allocation methods, state-administered leave programs, and the substantial and legitimate business reason exception provides an opportunity for practitioners to shape the final regulations. Comments are due by October 16, 2026, and the IRS has emphasized that electronic submissions via the Federal eRulemaking Portal (referencing IRS-2026-0496) are strongly encouraged. Practitioners should seize this opportunity to address ambiguities in the notice, such as the lack of safe harbors for blended premium allocations or the IRS’s undefined standards for the substantial and legitimate business reason exception.

The IRS’s broader enforcement posture, as evidenced by its automated underreporter (AUR) notices and audit activity, suggests that noncompliance with Section 45S will carry significant penalties. The IRS has historically targeted employers for missing or inadequate written leave policies, failure to maintain contemporaneous records for blended premium allocations, discrepancies between claimed credits and wage deductions, and discriminatory leave benefits favoring highly compensated employees. The IRS’s Chief Counsel Memoranda and audit manuals indicate that penalties under Section 6662 (20% accuracy-related penalty) are routinely applied in such cases. Employers should conduct a preemptive review of their leave policies, insurance arrangements, and tax filings to identify and correct deficiencies before the IRS does. This includes updating written policies to comply with the OBBBA’s amendments, reviewing insurance policies to ensure they cover only qualifying leave under Section 45S(e), coordinating with payroll providers to track wages paid to qualifying employees during leave, and modeling the tax impact of claiming the credit versus forgoing it and electing to deduct the full wages.

The permanence of Section 45S and the OBBBA’s expansion of eligibility present a rare opportunity for employers to claim a valuable credit while supporting workforce stability. However, the IRS’s heightened scrutiny and the notice’s technical requirements demand a proactive and meticulous approach to compliance. Practitioners must treat Notice 2026-28 not as a mere procedural update but as a comprehensive retooling of Section 45S compliance, with implications for leave policies, insurance arrangements, tax planning, and recordkeeping. The IRS’s emphasis on contemporaneous records and the forthcoming proposed regulations underscore that the era of informal or retroactive compliance is over. Employers who act now to align their practices with the notice’s guidance will avoid costly audits, penalties, and lost credits—while those who delay risk falling afoul of an increasingly automated and unforgiving IRS.