Our efforts to educate employers about the dangers and surprises associated with PTO cash‑outs (see, Chapter 13 and “When Having Your Cake and Eating It May Be a Bad Thing: Cautions About Cash-Outs of Unused Leave Or PTO”) are having an effect. Unfortunately, some of the changes and adaptations to MOUs regarding PTO cash-outs simply do not go far enough.
One of the newer “variations” that we have come across gives employees that have already accrued a certain amount of PTO the right to make an irrevocable election in calendar year 1 to receive a cash-out of a portion of their already accrued PTO as of the beginning of calendar year 2. For example, an employee who has already accrued 120 hours of PTO has the right prior to the end of this year to elect to receive a cash-out of up to 60 of those hours, which will not be paid until the beginning of next year.
Presumably the “thinking” behind this variation is that the employee must make an irrevocable election to receive additional compensation (or not to receive it) in the year prior to the year of actual receipt – and that this timing rule somehow avoids application of the “constructive receipt” doctrine. In our view, it doesn’t.
The reason it doesn’t work to prevent the employees who have the election from being taxable in year 2 is because the employees have already accrued or earned the PTO that is being cashed out. The consequence is that the employees are being given the absolute right to decide this year whether they will receive additional cash early next year. Yes, the fact that they cannot receive the cash-out this year will prevent the money from being taxed this year, but it will not keep the amount subject to the election from being taxable in year 2. Therefore, all employees who are given the election will have additional taxable income in year 2 even though they do not elect to cash out anything.
So, what’s still missing? In order for the above scenario to turn out correctly, the irrevocable election in calendar year 1 to cash out PTO must be made with respect to PTO that has not yet been earned and which will be earned in calendar year 2 or years into the future. Because the employee does not know whether he or she will earn a specific amount of PTO as of the beginning of year 2, the policy will have to be adapted to account for rates of accrual and the chance that the employee may leave early or not earn the PTO he or she elected to cash out.