PTO cash-out provisions are common. They also tend to be one of those handbook provisions that employers carry forward year after year without giving them much thought. But a seemingly simple option to cash out unused PTO can create an unexpected tax problem for employees.
Generally, if an employee currently has a choice between receiving cash or keeping another benefit, the employee may be treated as having received the cash for tax purposes even if the employee is not actually receiving the cash. Applied to PTO, the IRS has taken the position that when an employee can choose to cash out accrued PTO instead of using it or carrying it over, the value available for cash-out may become taxable when that choice is available.
For example, an employer’s handbook allows employees to cash out up to five days of unused PTO with the remaining, if any, rolled over at the end of the year, or in the alternative roll over all remaining amounts to the following year. Employee A has 20 days of unused PTO at year-end and chooses to carry over all 20 days. It is easy to assume there is no tax consequence because the employee did not actually receive any money. Instead, the value of the five days available for cash-out should be taxable to the employee in that year, even though no cash is received. The remaining 15 days are not taxable because they could not have been cashed out.
This does not mean employers cannot offer PTO cash-outs. The IRS has provided, in several private letter rulings, that an employee can avoid negative tax consequences by making an irrevocable cash-out election by December 31st of the year before the PTO will be earned. The employee is then taxed when the cash is actually paid or otherwise made available. Further, an employer that automatically cashes out a specified amount of PTO, without giving employees a choice between cash and keeping the PTO, does not face the same tax consequences.
If your PTO policy allows employees to decide whether to cash out, use, or carry over PTO they have already earned, it is worth another look. What looks like an employee-friendly benefit may create an adverse tax consequence before anyone receives a check. It is also important to keep in mind that state wage-and-hour and paid-leave laws may also restrict how PTO can be forfeited, carried over, capped, or paid out, so any change to a PTO policy should also be reviewed under the laws of the states where your employees work (including remote work). If you have any questions about PTO, or other leave administration issues, please contact any member of Bricker Graydon Wyatt's Employee Benefits practice group.
