PTO and constructive receipt

Potential traps for employers include the timing of, and cross-year accounting for, payroll tax liabilities from paid-time-off programs.
By Allen Tobin, J.D.

Many employers have paid-time-off (PTO) policies that allow employees to cash in some portion of their PTO when the balance reaches a certain level. Other employers offer to buy back unused PTO from their employees. (PTO refers to vacation, sick, and/or personal leave offered as an employee benefit.)

What is often overlooked in these situations is that the ability to convert unused PTO to cash constitutes constructive receipt of income and will subject the employees to taxes even if they do not receive any cash. It can also cause payroll complexities for the employer.

THE DOCTRINE OF CONSTRUCTIVE RECEIPT

Under Regs. Sec. 1.451-2(a), income not received in cash is constructively received by a cash-basis taxpayer in the tax year during which the income is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon the income at any time, or could have drawn upon it during the tax year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of the income's receipt is subject to substantial limitations or restrictions.

In the case of a plan that allows employees to convert unused PTO into cash, the IRS consistently has held that an employee is constructively in receipt of income as soon as the right to receive cash for the PTO becomes fixed (Letter Ruling 9009052). The same result should apply if the employer offers a one-time program to buy back unused PTO from its employees. With these plans, employees will have W-2 income equal to the cash value that can be requested for the PTO accrual.

Example 1: The employees of a company accrue two days of PTO on the last day of each month. Once an employee's unused PTO balance reaches 15 days during the year, the employee has the option to be paid in cash for any PTO days in excess of 15. An employee with no prior PTO balance who was employed on Jan. 1 took seven PTO days in June. At the end of December, the employee has a PTO balance of 17 days (24 days earned less seven days used).

Because the PTO balance at the end of December exceeds 15 days, the employee is eligible for a cash payout for the two days earned on Dec. 31. Even though the employee has received no cash compensation for those two PTO days, the employer is required to include their cash value in that employee's taxable wage base on Dec. 31. The employer should withhold and remit payroll taxes for those two days of PTO for the pay period including Dec. 31. If this amount is not reported as W-2 wages until used, the employer will be subject to penalties for failure to properly withhold federal and state income taxes, Federal Insurance Contributions Act taxes, Federal Unemployment Tax Act taxes, and State Unemployment Tax Act taxes. The complexity does not end there, however.

Example 2: In January of year 2, the employee earns two additional days of PTO and resigns on Jan. 31. Upon the employee's resignation, the company pays out 19 days of PTO—the 17 carried over from year 1 and the two days earned at the end of January of year 2.

Because the two days in December of year 1 were reported as W-2 wages in year 1, the company's payroll system will need to recognize that fact so that those amounts are not treated as W-2 wages again in year 2 when they are paid out. If the employer's plan allows employees to make an election before the year in which the PTO is earned to receive excess PTO in cash, the excess PTO will not be taxable to the employee until it is paid in cash or otherwise made available.

In Letter Ruling 200130015, a municipality entered into a collective bargaining agreement with certain employees allowing them to cash out some excess vacation hours prior to separation from service. Under the plan, an employee could elect irrevocably at any time on or before Dec. 31 of each year to receive cash for part or all of the amount of vacation hours that would otherwise accrue in the subsequent year. The letter ruling concluded that this arrangement did not constitute constructive receipt in the year before the vacation leave was earned, as the election was made before the employee's provision of services giving rise to the vacation leave.

REVIEW PTO PLANS AND PAYROLL SYSTEMS

Businesses should review their PTO plans to make sure there are no constructive receipt issues. They also should review their payroll systems to make sure the appropriate amounts are reported when an employee constructively receives income and when that income is later paid to the employee.

Editor's note: A version of this column also appeared as "Tax Clinic: Constructive Receipt Traps for Paid-Time-Off Plans," The Tax Adviser, September 2015, page 659.

Allen Tobin (allen.tobin@crowehorwath.com) is a senior manager at Crowe Horwath LLP in New York City.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

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