The COVID-19 pandemic has forced employers to get creative with their employee benefit programs to keep and attract talent. With employees working from home for the past two years, a new employee benefit option is becoming more popular – PTO buybacks programs. Offering this new benefit or loosening restrictions on existing PTO programs is great for employee morale, but it can cause unintended tax consequences under the constructive receipt doctrine.
A PTO buyback or cash-out program is an employee benefit program that gives employees an option to receive cash in lieu of accrued PTO. These types of benefit programs have become popular because many employees haven’t been able to use their accrued PTO due to COVID-19 canceling their vacation plans.
The problem with these plans is they create unintended tax consequences due to an arcane tax concept called the constructive receipt doctrine. In short, this doctrine taxes income, whether or not received, if the taxpayer has an unrestricted right to such income and may draw upon it at any time.
The classic example of this doctrine in practice is a sole proprietor’s attempt to defer income to a later year by holding a check received on December 31st and depositing the funds in January of the following year. The constructive receipt doctrine would require him to include income in the earlier tax year because the money was constructively received in that year; in other words, the doctrine does not allow taxpayers to turn their back on the receipt of income.
This issue with the constructive receipt doctrine arises with PTO buyback programs when the employees are given the choice to cash out their PTO, i.e., they are given an unrestricted right to receive income. Regardless of whether they choose to exercise the right, the existence of the cash option creates a taxable event for the employees.
For example, let’s say on December 1, 2022 an employer offers a two-week option to its employees to cash out up to 40 hours of accrued and unused PTO, payable in December 2022. Assuming all employees have at least 40 hours of accrued PTO, the employer would be required to include an additional 40 hours of wages on each employee’s 2022 W-2 regardless of their choice to cash out some, all, or no PTO. The constructive receipt doctrine requires employees to include in income the total amount of cash they could have received, at the time the option was made available, regardless of each employee’s ultimate choice.
How to Plan Around the Constructive Receipt Doctrine
With proper planning, employers can mitigate the effects of the constructive receipt doctrine. Here are some suggestions:
Hardship Provisions – adding a hardship provision to a PTO buyback program allows employers to offer a cash-out option in extraordinary circumstances without giving employees an unrestricted right to receive income. Hardship can be defined in several ways, but the goal is to put the decision in the employer’s hands. This way, only those employees who apply for and receives a cash-out benefit at the employer’s discretion will be subject to tax.
Prior-year Election – requiring employees to elect cash in lieu of PTO this taxable year for next year’s PTO is another way to protect employees who do not exercise the option. Subject to an exception for mid-year elections, the election should be made in the taxable year prior to the year in which the PTO is earned.
Hurdle Buyouts – adding a hurdle to a buyback program can also help. For example, a plan could offer to cash out PTO only in excess of 160 hours of accrued and unused PTO. This way, employees that do not accrue more than 160 hours of PTO will not have an option to receive cash and therefore will not be adversely affected by the constructive receipt doctrine.
Adding to or amending existing employee benefit programs can be important to retaining and attracting talent, particularly during the Great Resignation. When doing so, however, employers should ensure their plan does not backfire and create tax problems for their employees. We recommend employers seek professional tax advice anytime they make changes to their employee benefit programs, because even seemingly minor changes can have outsize tax consequences.