This article was originally published on Dec. 21, 2020 and has been updated.
Nearly all employers offer their employees some form of paid time off for vacation and other uses. Standard vacation or paid time off (PTO) policies have intuitive tax consequences. Essentially, the employer is paying the employee cash compensation when the time off is taken, and like any other cash compensation, it is taxable to the employee and deductible by the employer upon payment.
If your PTO policy has some common added features, though, the tax consequences are not quite as intuitive, and you may inadvertently create risk if you are not aware of the proper treatment.
Two common features that can create risk are PTO cash-out options and PTO donation policies.
A cash-out option is when employees are given the choice to take cash in lieu of PTO or to exchange accrued vacation time that exceeds a certain threshold for cash.
The trap with these features is that when the employee is given a choice between cash and PTO, the employee is treated as constructively receiving the cash when the option to receive cash becomes available, whether or not the employee exercises that option and actually receives the cash. In other words, the tax system views that option to choose cash today as good as actually receiving cash and does not allow an employee to control when the PTO is taxable by controlling when the money is delivered to him or her.
As long as employers are aware of this tax treatment, unintended consequences can be avoided. One approach is to follow the rules and treat the PTO amount as taxable compensation when the employee has the right to exchange it for cash, which also subjects the amount to income and payroll tax withholding at that time. Reporting the compensation in the proper period removes the risk of underpayment penalties and interest the employer otherwise has for failing to withhold. If this policy is used, the employer also needs its recordkeeping system to track that these amounts were reported as wages in a prior period so that they are not taxed a second time when the cash is actually paid.
Alternatively, a change in the facts can have a different tax result. If employees are required to make their choice to receive cash instead of PTO in the tax year prior to earning the PTO, then the employees are not treated as receiving cash in the earlier year. Since the employee has the right to make an election in the prior tax year to cash-out a portion of their PTO for the following tax year, the employee does not have a right to cash (i.e., constructive receipt) until the applicable PTO is earned in the following year. Care needs to be taken in designing this type of policy and any PTO carryover in order to avoid any inadvertent Section 409A or 457(f) deferred compensation taxation issues. Note that cashing PTO out upon an employee’s termination of employment is not taxed until the employee receives payment, because the fact that the employee has to leave his or her position to have a right to the cash is a significant enough barrier that the employee is not viewed as being in constructive receipt of the cash.
PTO donation policies
Another common type of PTO policy is an employer leave-sharing program that allows one employee to donate unused PTO days to another employee. The intuitive tax result in this situation would be for the donated PTO days to be taxable compensation to the receiving employee who actually used them. This is not the case, however. The trap in is that, under the assignment of income principle, individuals cannot avoid paying tax on income owed to them by simply assigning that income to someone else. Therefore, the tax rules generally require the donating employee who earned the PTO days to report taxable income, even though that individual chose not to receive the income. In this way, employers may inadvertently create risk by incorrectly reporting compensation with respect to the wrong employee.
There are, however, two exceptions to this rule. Pursuant to IRS Revenue Ruling 90-29 and IRS Notice 2006-59, employers may implement leave-sharing programs that permit employees to donate their unused PTO days to other employees affected by a medical emergency or major disaster, provided that the certain requirements are satisfied. Under such a program, any amount paid by the employer attributable to the transferred PTO days is treated as taxable compensation to the employee who received such PTO days (based on the value of the PTO received), rather than to the donating employee. If the leave-sharing program failed to satisfy the requirements of the IRS guidance, the donated PTO days would be treated as taxable compensation to the donated employee, and the recipient would likely be treated as receiving a nontaxable gift, depending upon the facts of the donation.
Further, as part of COVID-19 relief, the IRS in Notice 2020-46 temporarily permitted employer leave-sharing programs that allowed employees to have their unused PTO contributed in cash to a “qualified charitable organization.” Pursuant to the guidance, any such contributions made prior to January 1, 2021, would not be treated as taxable compensation to a contributing employee, provided that the charitable organization was of a type providing relief to victims of the COVID-19 in the affected geographic area.
Other considerations – Impact on qualified retirement plans
PTO may also have implications for qualified retirement plans. The definition of compensation used for nondiscrimination testing, and contribution and accrual limits applicable to qualified retirement plans may have special requirements for PTO. Further, if the plan document so provides, an employee may under certain circumstances elect to contribute unused PTO on a tax-free basis to a 401(k) plan under IRS Revenue Rulings 2009-31 and -32.
Employers typically offer PTO policies for business purposes to attract and retain talent and should not necessarily let unintended tax consequences steer their decisions whether to offer certain features or not. However, an understanding of the applicable tax rules is important so that when those features are offered, the employer is not neutralizing the good business effect with a downside of heightened tax risk.
Note also that employers should review all applicable state laws associated with their PTO and cash-out policies to confirm that they align with any state requirements.