Constructive receipt traps for paid-time-off plans.

• Author: Tobin, Allen

Many employers offer paid-time-off (PTO) policies that allow employees to cash in some portion of their PTO when the balance reaches a certain level. Other employers offer to buy back unused vacation or PTO days from their employees. What is often overlooked in these situations is that the ability to convert unused PTO or sick days to cash constitutes constructive receipt and will subject the employees to taxes even if they do not receive any cash. Constructive receipt of these amounts can also cause payroll complexities for the employer.

The doctrine of constructive receipt is summarized in Regs. Sec. 1.451-2(a). Under the regulation, income not received in cash is constructively received by a cash-basis taxpayer in the tax year during which the income is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon the income at any time, or so that the taxpayer could have drawn upon it during the tax year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of the incomes receipt is subject to substantial limitations or restrictions.

In the case of a PTO plan that provides employees with the discretion to convert unused PTO days into cash, the IRS consistently has held that an employee is constructively in receipt of income as soon as the right to receive cash for the PTO becomes fixed (Letter Ruling 9009052). The same result should apply if the employer offers a one-time program to buy back unused PTO or sick days from its employees. When these plans are in place, employees will have W-2 income equal to the cash value that can be requested for the PTO or vacation accrual.

The application of this rule is illustrated by the following:

Example 1: The employees of a company accrue two days of PTO on the last day of each month. Once an employee's unused PTO balance reaches 15 days during the year, the employee has the option to be paid in cash for any PTO days in excess of 15. An employee with no prior PTO balance who was employed on Jan. 1 took seven PTO days in June. At the end of December, the employee has a PTO balance of 17 days (24 days earned less seven days used).

Because the PTO balance at the end of December exceeds 15 days, the employee is eligible for a cash payout for the two days earned on Dec. 31. Even though the employee has received no cash compensation for those two PTO days, the employer...