iFor many years, employers have implemented paid time off ("PTO") cash-out arrangements. If not constructed properly, PTO cash-out arrangements can raise constructive receipt issues resulting in unexpected taxation. In this newsletter, we will briefly cover PTO cashout arrangements, the IRS’ position regarding constructive receipt and the potential tax consequences.
The constructive receipt doctrine requires that if an employee is given the option to receive cash compensation or another benefit, the employee is required to recognize the cash compensation that is made available as income, regardless of whether the employee actually takes the cash compensation when it becomes available. In applying the constructive receipt doctrine to PTO cash-out arrangements, the IRS has consistently taken the position that an employee will be taxed on the value of the accrued PTO days that an employee may elect to cash-out under the arrangement in lieu of taking or carrying over the accrued PTO days. This position is illustrated by the following example:
Ann has accrued 15 days of unused 2023 PTO in December 2023. Her employer permits her to cash-out up to 10 days of accrued PTO in December of each year. Ann chooses to carryover all 15 days of her unused PTO from 2023 to 2024. According to the IRS position, Ann will be taxed in the 2023 tax year on the value of the 10 days of unused PTO that she could have cashed out but elected to carry over to 2024. She will not be taxed on the additional 5 days of PTO that she is carrying over to 2024, because these 5 days were not available for cash-out.
If Ann’s employer did not allow any cash-outs of accrued PTO, Ann could have elected to carryover all 15 days of her unused PTO from 2023 to 2024 without including any amount in income for the 2023 plan year. Alternatively, if the employer did not give Ann a choice and instead had a policy of cashing out a certain number of hours of PTO without an election from the employee, there would be no constructive receipt considerations.
The good news is that the IRS has issued several private letter rulings that provide the parameters for establishing a PTO cash-out arrangement that does not fall under the constructive receipt doctrine. While the private letter rulings issued by the IRS can only be relied on by the party that received the ruling, the letters provide insight into the IRS’ position as to how they apply constructive receipt to PTO cash out arrangements. The IRS has indicated in these rulings that the constructive receipt doctrine will not apply to a PTO cash-out arrangement that requires an employee to make an election in the current year to cash-out PTO that accrues in the following year. This can be accomplished through a standalone policy or, in some cases, through a Section 125 plan. This type of arrangement is illustrated by the following example:
In December of each year, Jim’s employer permits employees to elect to cash-out up to 10 days of PTO that will be accrued in the subsequent year. Jim accrues 15 days of PTO each year. In December 2023, Jim elects to cash-out five days of the PTO that he will accrue in 2024. Because the election is for amounts that will accrue in a future year, the constructive receipt doctrine should not apply based on the position taken by the IRS in the private letter rulings.
Given the increasing complexity of PTO arrangements now involving buying, selling, cashouts, and carryovers, consultation with counsel is recommended when constructing a PTO arrangement.
