Paid Time Off, including Sick, Vacation, and the like policies, are an essential employee benefit, allowing workers to take time off while still receiving compensation. Many employers also offer PTO cash-out options where employees can receive payment for unused leave. However, these policies must be carefully structured to avoid unintended tax consequences under the IRS constructive receipt doctrine. If improperly designed, a PTO cash-out policy could result in employees being taxed on income they never actually received. This article explains how constructive receipt applies to PTO payouts and outlines strategies employers can use to structure PTO policies in a tax-compliant manner.
Under Section 1.451-2(a) of the Code of Federal Regulations, income is considered constructively received when it is credited to an employee’s account, set apart or otherwise made available so that the employee may draw on it at any time. The key factor in determining constructive receipt is whether or not the employee has unrestricted control over the income.
When applied to PTO cash-outs, the IRS has consistently ruled that if an employee is given the option to receive cash for accrued PTO, the employee is taxed on the amount they could have received, regardless of whether they actually take the payout.
PTO cash-out policies can create tax liabilities if they give employees unrestricted access to cash payouts. Here’s how constructive receipt applies in different scenarios:
- Example 1: PTO Cash-Out Option Without Restriction
Mary accrues 20 days of PTO in 2024. Her employer allows employees to cash out up to 5 days of accrued PTO in December. Mary chooses to carry over all 20 days instead of taking the cash. However, the IRS will treat the 5 days that could have been cashed out as taxable income for 2024, even though Mary didn’t take the payout. - Example 2: No Cash-Out Option – No Constructive Receipt
If Mary’s employer did not allow PTO cash-outs, she could carry over all 20 days without any tax consequences because no cash option was available. - Example 3: Employer-Mandated Cash-Out – No Constructive Receipt
Mary’s employer requires her to automatically cash out a certain number of PTO hours without giving any other option. In this case, the IRS does not apply the constructive receipt rule. Instead, the payment is treated as regular wages when received.
Employers can design their PTO cash-out policies, to prevent constructive receipt issues, by following IRS-approved strategies:
1. Advance Election Requirement
- Employees must irrevocably elect whether or not to cash out PTO by December 31 of the year before the PTO is accrued.
- The cash-out must be limited to PTO earned in the year of payment.
Example: Robert accrues 15 days of PTO annually. In December 2023, he elects to cash out 5 days of PTO that he will accrue in 2024. Since he made this election before earning the PTO, constructive receipt does not apply.
2. Financial Emergency Exception
- Employees can only cash out PTO in the event of an unforeseen financial emergency.
- The emergency must meet strict criteria:
- The employee must demonstrate a real financial emergency beyond their control.
- The amount of the cash-out is limited to what is needed to resolve the emergency.
- The employer has sole discretion to determine whether or not the request qualifies.
- This structure prevents employees from having open-ended access to PTO cash-outs, and minimizes constructive receipt concerns.
Employers with unrestricted PTO cash-out policies may unknowingly underreport employee wages and fail to withhold the appropriate taxes. This could result in:
- IRS audits and tax penalties
- Liability for back taxes owed on misclassified PTO payouts
- Increased tax burden on employees who may be unaware of constructive receipt implications
To avoid these risks, employers should review their PTO policies and implement restrictions that align with IRS guidelines.
Employers must be mindful of how they structure PTO cash-out policies to prevent unintended tax liabilities for both the company and employees. By requiring advance elections for cash-outs, or limiting cash-outs to financial emergencies, employers can avoid triggering constructive receipt. Given the complexities of tax compliance, it is advisable for employers to consult with legal counsel, experienced in labor matters, to ensure their PTO policies adhere to IRS regulations and mitigate risk.
From the payroll perspective, this brings on the proper handling if the constructive receipt comes into play. A taxable fringe benefit earning would needed to be added to record the taxable benefit, then when the constructive PTO is paid out in the future, it needs to be paid on a non-taxable basis. This poses the challenge to track how much time was already taxed and be able to separate the taxed and not yet taxed amount in the employee’s check.
While we make every attempt to ensure the accuracy and reliability of the information provided in this document, the information is provided “as-is” without warranty of any kind. Romeo Chicco or PayMaster, Inc. does not accept any responsibility or liability for the accuracy, content, completeness, legality or reliability of the information contained. Consult with your CPA, Attorney, and/or HR Professional as federal, state, and local laws change frequently.
