A number of employers, particularly public agencies, allow their employees to accumulate significant amounts of paid time off, vacation or paid leave (collectively PTO). This article alerts employers to certain practices and policies regarding the cash-out of PTO that could result in large, unexpected tax problems for their employees.
Most employers and their employees assume that the employees will be taxed on wages and PTO only when the employee actually receives the wages or takes the PTO. Unfortunately this is not always the case. The income tax concept of "constructive receipt" treats an employee as having received gross income during a taxable year to the extent that the employee could receive the income during the taxable year if the taxpayer had asked for it.
Put another way, a constructive receipt issue is likely to arise whenever an employee is given a choice between receiving (i) cash now or (ii) cash or some other benefit in the future. For example, if your PTO policy allows your employees to cash out up to $10,000 of accumulated PTO each year without restriction, they will have additional income each year equal to the total amount of PTO they could have cashed out – even if they do not actually cash out any of their PTO! If you have maintained a PTO policy of this sort, you should have it reviewed and analyzed immediately. It is quite likely that you have been under-reporting your employees' income and under-withholding various income taxes and payroll taxes.
So how can you allow employees to have their cake (accumulate PTO) and eat it occasionally (cash out PTO) without creating a big tax problem? There are a variety of recognized approaches. One is to require the employee to make a choice between accruing the PTO or receiving cash in lieu of the PTO in the year before the year when the PTO will be earned.
Because no employer can afford to have its employees taxed on the value of PTO they have not actually taken, immediately take a look at your PTO policies and practices to see if they provide for cash-outs. If so, get help to evaluate whether you and your employees already have a constructive receipt issue that needs to be dealt with or whether you can allow them to have their cake by adopting one of the available alternatives that meets your goals.