Q. Our policy lets employees carry over up to 100 hours of unused paid time off from year to year. We would like to change the policy to permit employees the choice between cashing out paid time off and carrying it over into the next year in order to encourage them to reduce their paid time-off accruals. Is this a problem?
A. Unfortunately, this will probably not be an advisable change. Under the theory of “constructive receipt,” if an individual is permitted the choice between a taxable benefit (the cash) and a tax-deferred benefit (the carryover paid time off) the IRS will generally treat the arrangement as if the employee had actually received the taxable benefit.
In this case, the employee would be taxed on the paid time off as if he or she had actually received it, even if the employee chose to carry over the paid time off into the next year.
Fortunately, this inconvenient tax result can be solved in two ways:
1. Eliminate the choice. In this case, the option to receive the cash triggers the constructive receipt. If the employee can carry over the unused paid time off but can’t choose to cash it out, the doctrine will not apply. In that case, generally, the employee will be taxed on the paid time off in the year it is actually used.
2. Allow the election, but comply with the timing guidelines. If an election is made far enough in advance, an employee can generally avoid the constructive receipt rules. To avoid their application, the employee must make his or her election before the beginning of the year in which the paid time off is earned.
As always, this advice may not be applicable to your particular paid time-off arrangement. Be sure to have your attorney review your paid time-off plan to determine the approach that works best for you.