Previously, I’ve written about the pitfalls of giving employees “too much choice” with respect to their pay, their paid time off and other benefits. Employee elections that are not properly designed can unexpectedly result in current taxation under either the “constructive receipt doctrine” or the “assignment of income doctrine.”
One of the important takeaways from our advice concerning cash-outs of unused leave or PTO, see www.focusonpublicbenefits.com/article, is that there should not be a tax issue – a constructive receipt problem – if the employer requires employees to make a choice between accruing PTO or receiving cash in lieu of the PTO in the year before the year when the PTO will be earned. In other words, it’s okay to give employees a cash‑out election so long as that election is made in a calendar year that is prior to the year in which the employee will earn the PTO that will be subject to the cash-out.
A recently issued IRS private letter ruling (PLR) illustrates how this type of “safe election” can be used to give employees somewhat greater choice and control over the use of their accumulated sick leave or PTO, without triggering current taxation. In PLR 201601012, the IRS advised the requesting taxpayer that if appropriate 401(k) plan and health reimbursement arrangement (HRA) amendments are made, it should be possible to give employees the choice among having a portion of the PTO they will earn in the next calendar year: (a) contributed by the employer to the 401(k) plan; (b) contributed by the employer to the HRA; or (c) contributed by the employer into a combination of the 401(k) plan and the HRA.
There are a couple of nuances worth noting. First, the PLR contemplates that the amounts “elected” by the employee to go into the 401(k) plan will be employer contributions, not employee elective deferrals. Second, the PLR contemplates that the amounts going into the HRA will also be treated as employer contributions. For more on HRAs and why they must be funded by the employer, see www.focusonpublicbenefits.com/article.
For our public agency audience, the ones saying “but we can’t have a 401(k) plan,” there does not appear to be any reason that this technique could not be structured using a 457(b) plan instead of a 401(k) plan. Remember, an IRS PLR is considered tax advice only to the requesting taxpayer and may not be relied upon as authority by other taxpayers. If you have questions about this, please let us know.
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 firstname.lastname@example.org or (916) 329-3685.