Compensatory time off or “comp time” is paid time off taken in lieu of pay. In the case of State and local governments, the Fair Labor Standards Act (FLSA) allows them to provide non‑exempt workers with comp time in lieu of overtime. State and local governments may also provide their exempt workers with comp time in lieu of regular pay.
In its simplest form, comp time is provided for in a memorandum of understanding or an employer-established comp time policy that allows, in certain instances, employees to accrue (be credited with) comp time in lieu of overtime pay or certain regular pay (in the case of exempt employees). Basic comp time accrues automatically and is mandatory – somewhat like vacation or sick pay. When comp time accrues automatically like vacation and in accordance with the applicable FLSA rules, there is no taxation or taxable event until the employee takes the comp time or has her comp time cashed out upon termination of employment.
However, in cases where employers give their employees the choice to either receive comp time or not, or to cash out already accrued comp time, you have the same income tax problem that typically arises in connection with PTO cash-outs – that is “constructive receipt.” For example:
- If the employer allows employees to decide on a payroll by payroll basis (typically by annotating their time sheets) whether to take comp time or not, all employees given that choice are taxable on the amounts that they could have taken as cash wages.
- Just like PTO cash‑outs, if employers give employees the option to cash out some of their already accrued comp time, all employees who have that choice are taxable on the amounts that they could have cashed out – even if they don’t actually cash out any of it!
- Some employers give their employees a mid-year election of whether to receive comp time or overtime pay. Others allow their employees to elect out of automatically provided comp time at any time. Both of these practices raise serious questions about whether these elections comply with the nonqualified deferred compensation rules under Internal Revenue Code section 409A, and their related IRS guidance.
If you are being too “flexible” with respect to your comp time practices, now is the time to look into them.