Section 45S Paid Leave Credit: A 2026 Guide for Small Employers After OBBBA

If you offer paid family or medical leave to your employees—or are even thinking about starting—Congress just handed you a permanent tax credit worth between 12.5% and 25% of those wages. For years, the Section 45S credit lived under a sunset clause, set to expire at the end of 2025. Small employers ignored it because writing a compliant policy felt like betting on a credit that might not exist next year. The One Big Beautiful Bill Act (OBBBA) ended that uncertainty.

Beginning with tax years that start after December 31, 2025, Section 45S is permanent, easier to qualify for, and—for the first time—available based on insurance premiums you pay rather than just leave wages actually used. If you have between two and a few hundred employees, this is one of the most overlooked tax credits in the code. Here's exactly what changed, who qualifies in 2026, and how to set up a policy that survives an audit.

What Section 45S Actually Pays You

Section 45S is a federal tax credit for employers who voluntarily provide paid family and medical leave (PFML) to their workforce. The credit equals a percentage of the wages you pay to a qualifying employee while they're on leave for an FMLA-defined reason.

The applicable percentage starts at 12.5% if you pay 50% of normal wages during leave. Each percentage point above 50% adds 0.25% to your credit, capped at 25% when you pay 100% of normal wages. The credit applies to up to 12 weeks of leave per employee, per tax year.

A worked example makes this concrete. Say you have a salaried employee earning $60,000 a year (roughly $1,154 per week), and your written policy pays 70% of normal wages during leave. The employee takes eight weeks of leave for the birth of a child.

• Wages paid during leave: $1,154 × 0.70 × 8 = $6,462
• Applicable percentage: 12.5% + (20 × 0.25%) = 17.5%
• Section 45S credit: $6,462 × 0.175 = $1,131

That credit flows through Form 8994 to Form 3800 (the General Business Credit) and reduces your federal income tax dollar for dollar. The trade-off: you must reduce your wage deduction by the credit amount, so the net benefit depends on your marginal rate. For a small business owner taxed at 24%, a $1,131 credit is roughly equivalent to an $800 wage deduction—but it's a credit, not a deduction, which is materially better.

What OBBBA Changed for 2026

Several barriers that kept small employers out of the program are gone or relaxed.

The Credit Is Permanent

This is the biggest change. Pre-OBBBA, the credit was scheduled to disappear after December 31, 2025. Now it's a fixed feature of the tax code. You can build a multi-year leave program around it without wondering whether it will exist when you file.

Six-Month Employees Now Qualify

Before 2026, a "qualifying employee" had to be on your payroll for at least one year. OBBBA cuts that to six months at the employer's election. If you write your policy to extend leave eligibility to six-month employees, those employees count toward your credit. This matters for high-turnover industries—retail, hospitality, food service—where many workers never reach a one-year anniversary.

The Income Cap Now Tracks the HCE Threshold

A qualifying employee's prior-year compensation can't exceed 60% of the highly compensated employee threshold under Section 414(q)(1)(B). For 2026, that means employees earning under approximately $96,000 in 2025 are eligible. The cap rises automatically with inflation—no more wondering when Congress will index it.

The New Premium Method

This is the single biggest practical improvement for small employers. Pre-OBBBA, you could only claim the credit on actual leave wages paid. If no employee took leave in a tax year, your credit was zero, even if you'd built and funded a benefit.

Starting in 2026, employers who fund PFML through an insurance policy can claim the credit on the insurance premiums paid, regardless of whether anyone used the benefit during the year. For a small employer, this turns a contingent credit into a predictable one. You're effectively receiving a 12.5%–25% subsidy on the cost of your PFML insurance.

State-Mandated Leave Coordination

Previously, leave required by a state or local law didn't count at all. OBBBA now allows employers to claim the credit on leave that exceeds state or local mandates. If your state requires four weeks and you offer twelve, the eight extra weeks can generate credit. This unlocks the program for employers in states like California, Washington, Colorado, and New York that already have PFML laws on the books.

Eligibility Checklist for 2026

You qualify for the credit in a given tax year if all of the following are true.

Written policy. You have a written policy in place, signed and dated, before any leave is taken (or before the end of the year for a first-year, retroactive policy under transition rules). The policy must meet specific design requirements explained below.

Two-week minimum. The policy provides at least two weeks of paid leave per year to every qualifying full-time employee, prorated for part-time workers (those customarily working under 30 hours per week, or under 20 hours under the new rules for the two-week minimum requirement).

50% wage replacement floor. The policy pays at least 50% of the employee's normal wages during leave.

FMLA-qualifying reasons only. Leave must be designated for one or more of the six FMLA reasons: birth and bonding, adoption or foster placement, caring for a family member with a serious health condition, the employee's own serious health condition, military caregiver leave, or qualifying military exigency.

Non-interference language. The policy must include language preventing retaliation or interference with an employee's right to use the leave.

Income cap. The qualifying employee earned less than 60% of the HCE threshold in the prior year ($96,000 for 2026 calculations).

Employment duration. The employee has been on payroll for at least 12 months—or six months, if you elect that lower threshold in your policy.

A frequently missed detail: there is no minimum employer size. You can be a four-person LLC and qualify, even though FMLA itself only applies to employers with 50+ employees. Section 45S simply borrows FMLA's definitions of qualifying leave reasons—it doesn't borrow the size threshold.

Writing a Policy That Survives an Audit

The most common reason small employers lose this credit isn't math—it's a defective written policy. The IRS has been clear that a generic "PTO can be used for any reason" handbook section does not qualify, no matter how generously you pay during leave.

A compliant policy needs five things working together.

1. Specific Designation

The policy must specifically designate paid leave for FMLA-qualifying purposes. A combined PTO bucket that mixes vacation, sick, and family leave fails this test. If your handbook says "employees accrue 15 days of PTO that may be used for any purpose," none of that counts toward the credit, even if an employee uses it for a qualifying birth.

The fix: carve out a separate paid family and medical leave benefit. It can run concurrently with FMLA and overlap with state PFML where relevant, but it must exist as a distinct, named benefit in the policy.

2. Universal Application

The policy must apply uniformly to all qualifying employees. You can't offer 12 weeks to managers and two weeks to hourly staff. You also cannot exclude entire job classifications.

You can, however, prorate part-time employees and impose the six-month or twelve-month employment requirement on everyone equally.

3. Communication Requirement

If you have a written policy but employees don't know it exists, the IRS treats the leave as not being "provided" for credit purposes. You must communicate the policy in a manner reasonably designed to reach every qualifying employee—handbook updates, all-hands emails, or printed memos posted in the workplace all qualify if used consistently.

4. Non-Interference Language

A simple paragraph stating that the employer will not interfere with, restrain, or deny an employee's rights under the policy, and will not discharge or discriminate against any employee for opposing a violation. The IRS provides model language in Notice 2018-71.

5. Effective Date

The policy must be in writing and in effect before leave is taken. There is a narrow first-year transition rule allowing retroactive adoption, but you cannot rely on it as a planning tool. If you're considering adopting a policy for 2026, get it signed and dated by year-end.

How the Premium Method Actually Works

The new premium-based method is worth a deeper look because it changes the planning math.

If you purchase a PFML insurance policy from a commercial carrier, your tax credit equals the applicable percentage multiplied by the premium paid—not the wages paid out by the insurer. The applicable percentage in this case is determined by the replacement rate offered by the insurance policy, not by what you'd otherwise pay an employee directly.

Practical implication: a small employer with no current leave program can buy a PFML insurance policy in 2026, deliver a benefit they didn't have before, and recover 12.5%–25% of the premium cost as a federal tax credit. For a 25-employee firm, that often offsets a meaningful share of the program's net cost.

The catch is that detailed regulations on the premium method haven't been issued yet. The American Institute of CPAs has formally requested guidance from Treasury, and several questions remain open—including how to handle policies that cover both qualifying and non-qualifying leave, and how to allocate premiums when only some employees are credit-eligible. Expect proposed regulations during 2026; until then, work closely with a tax advisor and document your assumptions.

Recordkeeping: What to Save and for How Long

Tax credits are audit magnets. Section 45S has produced enough confusion that the IRS routinely asks for documentation. At minimum, retain for at least three years after filing the return:

• The signed written policy and any amendments, with effective dates
• Evidence the policy was communicated to employees (emails, posted memos, handbook acknowledgments)
• Payroll records showing wages paid during leave, separated from regular wages
• For each leave instance: the qualifying FMLA reason, dates of leave, and the employee's employment start date
• For premium method claims: insurance contracts, premium invoices, and proof of payment
• Form 8994 worksheets and the Form 3800 carryover schedule

Keeping these records cleanly separated is where most small businesses stumble. PFML wages need to be identifiable inside your general ledger—not buried in a generic "payroll" account. The same applies to insurance premiums: a separate expense account for PFML insurance avoids painful reconciliation later.

This is also where careful bookkeeping pays for itself. Setting up dedicated accounts for leave wages, leave-related insurance premiums, and the corresponding tax credits from day one means that when you file Form 8994, you can pull the numbers in minutes. When you can't, you spend a billable weekend reconstructing them from bank statements—and that's after you've already paid your CPA.

Common Mistakes That Kill the Credit

A handful of errors account for most of the credit denials and audit adjustments around Section 45S.

Combining PTO into one bucket. As noted, generic PTO that can be used for any purpose fails the specific-designation test. Carve out PFML as a distinct named benefit.

Counting state-mandated leave twice. Under OBBBA's new rules, you can claim the credit on amounts that exceed state or local mandates, not on the mandated portion. Double-counting is an easy way to invite an exam.

Ignoring the income cap. Employees who crossed the HCE threshold in the prior year don't qualify. Run a quick prior-year compensation report before assuming a leave instance is creditable.

Forgetting the deduction reduction. Your wage deduction must be reduced by the credit you claim. If you're using accounting software to draft Schedule C or your business return, this adjustment is easy to miss.

Treating part-time and full-time identically. Part-time employees must receive a prorated benefit. Failing to prorate often means the policy is more generous than required—which is fine for employees, but you only claim credit on amounts actually paid.

Missing the policy effective date. Adopting the policy mid-year means leave taken before adoption doesn't qualify. Plan ahead.

Should You Adopt a Policy for 2026?

Run a quick estimate before committing. Add up the wages your business already pays during informal leave (parental, medical, bereavement), and apply the 12.5%–25% credit. If the result covers a meaningful share of the cost of formalizing the program—or if you're in a state that already mandates PFML and you'd be operating the program anyway—the answer is usually yes.

For employers in PFML-mandate states, the math is especially compelling. You're already running the program; OBBBA now lets you recover a portion of the cost of the benefits you offer above the state minimum. For employers in non-mandate states, the premium method is the cleanest path: buy a PFML insurance policy, claim the credit on the premium, and let the carrier handle administration.

The credit also stacks well with other small-business tax benefits like the Section 45F employer-provided childcare credit and the Work Opportunity Tax Credit. Coordinating these in a single year can produce substantial reductions in federal liability for a small business.

Keep Your Tax Credits Audit-Ready

Section 45S rewards employers who treat paid leave as a deliberate, documented program rather than an informal practice. The same principle applies to tracking the credit itself: clean books, separated accounts, and version-controlled records turn a stressful audit into a thirty-minute conversation. Beancount.io provides plain-text accounting that gives you complete transparency over your payroll, leave wages, and tax credit calculations—every entry traceable, every report reproducible. Get started for free and build a financial system that's ready for whatever the IRS asks next.