United States

Do your PTO policies create tax complexity?

TAX BLOG  | 


Employers seeking to attract and retain the best employees often turn to creative incentives around vacation and sick leave policies, (a.k.a., paid time off or PTO). The ability to cash out unused PTO upon leaving the company is a variation that has become increasingly common and has a fairly straightforward tax impact. Some progressive companies are also offering employees the option to cash out PTO on an as-needed basis. This creates an interesting tax predicament.

In a typical end-of-employment cash out situation, the employee has not “earned” the PTO cash equivalent—that is, a cash out option is not available—until the point employment is terminated. As a result, income and payroll taxes are withheld at the time the payment is made to the employee.

It’s reasonable to assume the same applies when an active employee takes advantage of a PTO cash out option. The IRS sees it differently.

In the tax system, the ability to receive cash is viewed the same as if the cash is actively received, meaning that you would be expected to withhold income and payroll taxes at the time a cash out becomes possible, whether or not the employee actually enacts the option. This would obviously surprise your employee—and possibly take away the perceived advantage of a flexible PTO benefit. If you’ve got such a policy in effect and are NOT actively withholding taxes until an employee elects to cash out, you may be opening yourself to risk. Either scenario is in opposition to the goal of offering progressive benefit options.   

How do you offer a PTO cash out option that rewards employees for staying while keeping the IRS satisfied? You need to fully understand the tax impact of the PTO policy you put in place and fully communicate its effects to your employees. I’ve outlined some of the possible tax treatments for PTO cash outs, as well as the taxation of PTO donations, in a related article, Beware of traps with paid time off policies.

Human resources, payroll and tax should be strategic partners when it comes to designing benefit programs that attract and retain employees. You want to be sure the intention of your offerings is supported through the implementation without creating a tax risk. That means understanding the intricacies of the code, considering real-world applications and structuring your benefits and benefit communications accordingly. 


Anne Bushman

Senior Manager

Anne advises companies on various executive compensation, employee stock ownership and employee benefits matters affecting closely-held businesses. Reach her at anne.bushman@rsmus.com.

Areas of focus: Washington National Tax