If you are an employer that has a vacation buy-back policy for its employees, you should be aware of potential unintended tax consequences. A vacation or paid time off (PTO) buy-back policy gives eligible employees the option to either take their accrued vacation or PTO as time off, or receive a portion of their accrued time as extra compensation. The issue is whether giving employees the option to exchange unused vacation or PTO hours should be included in employees' income, even if the option is not exercised.
- Vacation buy-backs are meaningful benefits to employees.
- Without careful design of a vacation buy-back program, employees could be penalized for underpayment of tax.
- Employers could be penalized for failure to withhold and pay employer-related taxes.
- Vacation buy-back programs can be found in both HR policies and collective bargaining agreements.
The Internal Revenue Code provides that amounts are included in the taxpayer’s gross income when actually or constructively received in the taxable year during which the amounts are credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available to the taxpayer to be drawn upon at any time, or could have been drawn upon during the taxable year if the taxpayer’s notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.
The IRS expresses its opinion on the constructive receipt issue in numerous private letter rulings. In particular, a 1990 ruling addresses the option to cash out vacation that is included in two collective bargaining agreements. Under one of the agreements, employees may exchange their vacation days for cash at any point during the year. The employees must provide notice at least 10 days in advance of the payroll period, and an employee may not have more than 480 hours of leave to his credit. Ultimately, the IRS ruled that having the option to cash out PTO is constructive receipt and should be included in employees’ wages. The 10 days advance notice and maximum hour requirements were not substantial enough restrictions to exclude the income.
The constructive receipt doctrine was found to not apply in an IRS 2001 ruling because the right to make an election to receive cash in lieu of vacation was made in the year before vacation was earned. In general, where a taxpayer has entered into a binding contract or agreement to defer income before it is earned, the amounts deferred are not includible in income by a cash-basis taxpayer until it is received.
The 2001 ruling describes a policy that contained sufficient restrictions such that employees were not in constructive receipt. A policy that requires employees to make an election to receive cash in lieu of vacation days prior to the year in which the vacation days are earned will not create additional taxable income for employees.
- Review paid time off policies, including vacation, sick and personal.
- Review collective bargaining agreements for paid time of policies.
- Review restrictions, if any, on elections to receive cash in lieu of time off.
Employers should review their policies, agreements and restrictions to determine if their employees could be in constructive receipt of income for the current year and prior years. Substantial restrictions are key to supporting an organization’s conclusions that its employees are not in constructive receipt.
Although the private letter rulings are binding only upon the employer that sought the ruling, they do provide guidance to employers seeking to provide employees with vacation buy-back policies. Employers who wish to add this feature to their benefit programs may want to request their own private letter rulings from the IRS.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.