United States

Beware of traps with paid time off policies

INSIGHT ARTICLE  | 

Nearly all employers offer their employees some form of paid time off for vacation and other uses. Standard vacation or paid time off (collectively referred to herein as “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 cashout options and PTO donation policies.  A cashout option is when employees have 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 the employee is treated as constructively receiving the cash when his or her option to receive cash becomes available, whether he or she exercises that option and actually receives the cash or not. In other words, the tax system views that option to receive cash today just as good as actually receiving cash and does not allow an individual to control when the tax is paid 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 way 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 has a different tax result. If employees must make their choice to receive cash intead of PTO in a tax year prior to earning the PTO, then the employee is not treated as receiving the cash in the earlier year. This is because although the employee has the right to make an election that year, he or she does not yet have a right to cash until the applicable PTO is earned in the following year.

Note that cashing PTO out upon an employee’s termination of employment is also 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.

Another feature of some PTO policies is a program that allows employees to donate their unused days to other employees. Obviously, the intuitive 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. So 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 a program is designed to meet all of the requirements in the guidance. If met, the intuitive result occurs in which the employee who uses the PTO has taxable compensation rather than the employee who donated it. 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.

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.

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