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Offering Your Employees PTO Payouts or Carryovers? Don’t Forget About Constructive Receipt

November 15, 2022

by Leah Davis, CPA

It’s fairly common for an employer to allow employees to cash in some of their paid time off (PTO) or to carry over earned PTO benefits into the next calendar year. But what isn’t so common is the knowledge of how the IRS doctrine of constructive receipt applies in these situations. And this can be problematic for employers.

To give you a little background: Generally speaking, constructive receipt is an IRS tax doctrine that dictates when employees should recognize income related to non-cash wages, including PTO and, for public employers, compensatory (or comp) time. Although the regulation applies to all employers, it has specific implications for those that offer the option of a PTO benefit payout or carryover into another calendar year.

Here’s what all employers should know about constructive receipt.

The basics of constructive receipt

Per the IRS, the moment when an employer presents an employee with the option to receive cash compensation is when the compensation should be realized and reported as income. Of course, if the employee elects to receive cash, it is taxed upon receipt, meaning no special action is needed.

On the other hand, if an employee waives the option to receive cash and rolls the benefit into the next calendar (i.e., tax) year, this creates an income recognition and reporting issue. In this situation, the employer—unless they meet specific administrative requirements—must report (and tax) the value of the benefit in the tax year during which the employee had the option to convert it to cash. Later, when the benefit is actually used, the employee would receive the cash value of the benefit on a post-tax basis.

Common triggers

Here are two common situations in which constructive receipt would apply:

  1. When public sector employees are allowed to choose, after the hours have been worked, between overtime pay or receiving compensatory (comp) time (this is illegal for non-public sector employees, of course).
  2. When employees are given the opportunity to choose between PTO (including vacation, sick, and/or comp time) payouts or carryovers.

What should employers do to comply?

There are several things you can do to ensure compliance with constructive receipt.

If, as a public employer, you offer comp time in lieu of overtime pay, you could take one of the following actions:

  • Do not allow employees to choose between receiving overtime pay or comp time. Either all overtime is paid out or all overtime is converted to comp time.
  • Require that all employees formally designate, in advance of working the hours, how they wish to handle overtime.
  • Require that all accrued comp time be paid out in the same payroll tax year it is accrued.

If you offer the choice of PTO (including vacation, sick, and/or comp time) payout or carryover, you could take one of the following actions:

  • Stop allowing employees to choose between a PTO payout or carryover. Either PTO is always paid out or PTO is always carried over into the next calendar year.
  • Require that all employees formally designate, in the preceding payroll tax year, what they wish to do with any remaining PTO time (e.g., will they cash it out or carry it over) at the end of the upcoming payroll tax year.
  • Consider a Section 125 “cafeteria” plan that allows employees to “sell” PTO/vacation/sick leave in return for cash or nontaxable benefits, or a Section 457(b) plan that provides an election to convert some or all of their accrued PTO to a retirement benefit. Each of these plans, however, comes with specific requirements and limitations, so it’s important to understand the fine print.

How does constructive receipt apply in your organization?

Now is a good time to review your PTO and comp time policies to ensure you’re avoiding sticky constructive receipt triggers. If your organization were to be audited, failing to comply with constructive receipt could become a potentially costly—and most definitely time consuming—issue. Thankfully, complying with the doctrine can be fairly straightforward.

If you have questions about constructive receipt and how it applies to your organization, reach out to our team today.


Meet the Expert

Leah Davis, CPA

With experience and empathy, Leah develops customized solutions to help employers solve their people challenges.

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