You Can’t Touch That: Permitting Cashouts of PTO May Create Tax Traps for Employees and Employers

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by Bret F. Busacker

As we approach year end, employers should give some thought to reviewing their PTO policies for the coming year. One of the most common tax traps that we see is employers offering employees the right to cash out their PTO.

“It’s their PTO, and if they have accumulated a large balance, then we want to encourage them to get the large PTO accrual off the books,” is a common explanation we hear from employers.

Not so fast. Giving an employee a choice between current cash and rolling over PTO hours accelerates the taxation of the employee’s PTO hours (even if the employee never elects to cash them out). Many employers are surprised to learn that an obscure IRS rule known as “constructive receipt” generally requires an employer to treat PTO as taxable wages at the earliest time the employee is able to elect to cash out the PTO.

This practice can have significant tax implications for employees and tax reporting and withholding implications for employers.

There are a number of ways employers may provide for PTO cashouts that comply with tax laws:

  • Annual cashout elections. Employees may irrevocably elect by December 31st to cash out PTO accrued in the following year.
  • Haircuts on cashout While not having the force of law, the IRS has permitted some employers to permit cashouts so long as the employer requires that at least 30% of the cashed out amount is forfeited by the employee.
  • Formula-based cash. A PTO program may have a formula that provides for cashouts a limited number of times per year (i.e., all excess PTO will be cashed out on the last payroll of December).
  • Cafeteria plan cashout. Employers may allow employees to buy additional PTO and sell PTO through a cafeteria, but the cafeteria plan model has the “use it or lose rule” attached to it, which limits its helpfulness for employers that allow PTO rollovers.

Any changes employers make to bring their PTO programs into compliance with tax rules should be made with an eye to complying with applicable state wage laws. For example, an employer in most states could not simply convert their PTO program to a “use it or lose it” program to mitigate tax concerns. This would violate most state wage forfeiture rules.