INSIGHT ARTICLE |
Authored by RSM US LLP
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 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 feature of PTO policies is a program that allows employees to donate their unused days to other employees. The intuitive taxation result would be for the employee who used the PTO and received the benefit to report the income. The trap in these situations is the assignment of income principle that generally provides that individuals cannot avoid paying tax on income owed to them by simply assigning that income to someone else. Therefore, the tax rules would generally require the individual who earned the PTO to still report the income, even though he or she chose not to receive it. Accordingly, employers can again inadvertently create risk by reporting wages to the incorrect employees.
The IRS has provided guidance that allows exceptions for two major categories of PTO donation programs—medical and major disasters—if the program is designed to meet all of the requirements in the guidance. These programs allow employees to transfer their PTO to impacted employees. If the IRS guidance is met, the employee who receives the PTO has taxable compensation (based on the value of the PTO received) rather than the employee who donated the PTO. If a program does not meet the specific requirements of one of these exceptions, though, the donor has taxable wages, and the recipient is likely treated as receiving a nontaxable gift, depending upon the facts of the donation.
The IRS issued Notice 2020-46 permitting employer leave-based donation programs in which employees can elect to forgo their PTO in exchange for cash payments that the employer makes to qualified charitable organizations. The cash payments are not considered taxable compensation to the employees forgoing their PTO provided the contributions to the charitable organization are for the relief of victims of the COVID-19 pandemic in the affected geographic area and are made before Jan. 1, 2021.
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.
This article was written by Anne Bushman, Toby Ruda and originally appeared on 2020-12-21.
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