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
[ILLUSTRATION OMITTED] 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. [ILLUSTRATION OMITTED] 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. …