Recently, I spoke to a roomful of public agency human resources managers. As I sometimes do, I took a few informal surveys of my audience. One of the questions I posed was: “How many of your agencies allow employees to cash out some or all of their accumulated vacation, paid time off, or sick leave?” Not surprisingly, roughly 75% to 80% of the represented agencies said that their HR policies and MOUs provide for the cash-out of significant amounts of PTO – with little or no restriction. When I asked why they did this, most responded: “Because practically all other agencies do this as well.” So, if everyone is doing this, what’s the problem?
The problem is that this practice creates a “gotcha” income tax problem for most of the agency’s employees – particularly, those who do not elect to take or cash out their PTO. Most people I speak with have a hard time appreciating why an employee with hundreds of hours of unused PTO would be taxable on the value of PTO that they do not either take or cash out. But, an important concept in our tax laws, known as “constructive receipt,” can make a person taxable on income (cash) that the person could take, but chooses not to. It’s kind of like gaining a few extra pounds just because you bought a container of ice cream. As explained in detail in our article, “When Having Your Cake And Eating It May Be a Bad Thing: Cautions About Cash-Outs Of Unused Leave Or PTO,” this is more than a tax problem for employees. Employers with such policies have almost certainly under-reported income taxes and payroll taxes!
We are repeating our cautions and advice on this topic because we strongly believe that this is still a widespread practice and problem. If your agency has a policy of allowing PTO or vacation buy-backs or cash-outs, you should have the policy reviewed immediately. There are a number of things that employers can do to stop the problem and prevent future cash-outs from having unsettling and unanticipated tax effects.
Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at email@example.com or (916) 329-3685.