The saying goes, “No good deed goes unpunished.” Nobody knows that better than HR professionals, where “being kind” to employees, such as by making an exception to a company policy, often leads to problems down the road. While experienced professionals often see these types of problems coming from a mile away, many are unaware of the hidden risks their companies’ discretionary cashout PTO policies—often adopted with the best intention to give employees the greatest flexibility over their accrued PTO—might be creating, not only for their companies, but also their employees.
What Is a Cashout PTO Policy?
Many employers allow (or require) employees to “cash out” a portion of accrued, but unused, paid-time off (whether styled as sick leave, vacation time, or the more generic PTO). Such policies allow employees to convert accrued PTO into cash without having to take any leave from work. Companies like cashout policies because they remove accrued liabilities from their books, while giving employees greater flexibility with their PTO benefit; employees like cashout policies because, let’s be honest, who doesn’t like a little extra cash?
Unanticipated Tax Consequences
While there are potential advantages—and disadvantages (are you incentivizing employees not to take needed time off so as to cash out accrued PTO?)—to cashout PTO policies, we’re not going to weigh in on their merits here. Instead, we want to flag a tax risk that—from my observations—many HR professionals have never considered.
Our friends at the IRS are always concerned that employers and employees properly pay their employment taxes—and pay them at the right time. The IRS’ general rule is that income taxes must be paid in the year in which the taxpayer receives income (“actual income”) or is entitled to receive it (“constructive income”). The IRS’ “constructive income” doctrine requires taxpayers to pay taxes in the year they could have received the income, even if they delayed actual receipt into a future tax year.
Typically, when an employee uses PTO, there is actual receipt of income, taxes are paid in the year the PTO is paid out, and no constructive income issues arise. There also are no constructive income issues with “use-it-or-lose-it” policies—where unused PTO above threshold limits set out in the PTO policy is automatically forfeited—because the employee never has a right to convert the unused portion into cash. Mandatory cashout policies likewise typically are not an issue, because the employee receives and reports actual, taxable income at the time the cashout is made.
But discretionary cashout policies—where employees elect whether or how much accrued PTO to cash out—potentially require the employer and employee to recognize constructive income, with serious tax consequences. For example, let’s say your policy allows employees, at the end of each year, to cash out any accrued PTO above 100 hours. At the end of the year, Jane has accrued 140 hours of PTO. She could cash out 40 hours, but she knows she has a big European vacation scheduled for next February, so she only elects to cash out 10 hours of PTO. In this scenario, Jane has 10 hours of actual income—the 10 hours she converted to cash—and 30 hours of constructive income—the hours she could have converted to cash in that year. Under the IRS’ constructive income rules, Jane and the employer would owe taxes on all 40 hours of PTO that Jane could have converted to cash, whether she actually converted them or not.
This is not an ideal situation for anyone (other than the US government coffers). The employee will owe income taxes on wages not yet received (which could present cash-flow issues); and it can be a nightmare for employers to track which accrued hours have already been taxed.
Avoiding (or complying with) these constructive income rules
If your company maintains (or wants to implement) a discretionary cashout PTO policy, there are some potential workarounds to avoid these constructive-income complexities.
- The IRS seems to countenance plans that allow a discretionary (but irrevocable) election in one tax year for the cashout in the following tax year of PTO that otherwise would have accrued in that second year. In that scenario, that portion of future PTO to be paid in cash will be actual income in the year it is received, but there will be no constructive income for the amounts that accrue in the future as PTO.
- The IRS allows employers to convert PTO into a contribution to the employee’s traditional 401(k) account. That conversion is not a taxable event, but the contributions will be taxed as income when they are withdrawn, like any other plan withdrawal.
- The right to receive income does not trigger constructive income when that right is subject to substantial limitations or restrictions. That exclusion can apply to PTO cashout policies where, for example, the policy only allows cashouts in cases of a bona fide financial emergency.
When drafting a discretionary cashout PTO policy, you should engage your employment and tax counsel to determine whether your policy will trigger any constructive income obligations (and otherwise would not run afoul of Internal Revenue Code §409A, which governs certain deferred compensation arrangements, but with an exception for bona fide vacation and sick leave policies). And if your company already maintains a PTO policy that required it to (but it did not) constructively recognize constructive income in a prior year, your company could be required to recalculate employee wages in those years, issue amended W-2 forms, and report unpaid back taxes to the IRS. Again, you should work with your counsel to assess the company’s potential liabilities and best remedial actions.
Charles E. McClellan
Foulston Employment Law Attorney