Question:

Our company allows employees to sell up to 40 hours of their accrued PTO (accrued vacation) each year.  If an employee elects to sell the accrued PTO, we pay it out in a lump sum at the end of the year.  Does this raise any concerns?

Answer:

Yes it does. The Internal Revenue Service (“IRS”) view is that if an employer allows employees to elect to sell accrued PTO, then all employees should be treated has having elected to sell the maximum amount allowed. This is based on the doctrine of constructive receipt.

Under the doctrine of constructive receipt, a benefit is includible in an employee’s wages and income at the time the benefit is made available to an employee.  See Code § 451; 26 C.F.R. § 1.451-2(a).  Vacation leave, PTO, or other accrued leave earned but not taken (collectively, “accrued PTO”) represent an exception and are included in wages when taken rather than when earned.

The IRS views accrued PTO as future wages to be paid to an employee.  Therefore, the IRS views an employee’s ability to elect to have accrued leave paid to the employee as the employee being in constructive receipt of the accrued leave.  This is the case even if the employee does not elect to be paid the accrued leave – simply giving the employee the election means the employee is in constructive receipt of the accrued leave.  For example, the IRS has indicated an employer cannot allow an employee to choose whether to contribute leave to a retirement or retiree medical plan because then the employee would be in constructive receipt of the accrued leave.  See Rev. Rul. 75-539, 1975-2 C.B. 45; Priv. Ltr. Rul. 90-09-052 (Dec. 6, 1989).  Revenue Ruling 75-539 addresses an employee election at the time of an employee’s termination, but the same constructive receipt principle applies to an employee’s election regarding the sale of accrued vacation during employment.

The following are situations which do not result in constructive receipt:

- The employer unilaterally requires all employees to sell up to 100 hours of accrued vacation.  Because the amount is included in income and the employee does not have a choice, there is no problem with this approach.

- The employer allows an employee to sell vacation that will be earned in the future.  For example, at open enrollment in 2014, an employee may elect to see up to 40 hours of vacation that the employee will earn in 2015.  The employer then pays this out pro rata each pay check or in a lump sum at the end of the year (or when an employee terminates).Because the employee has not yet earned the vacation time, there is no constructive receipt.

If you have or wish to adopt a program to allow the sale of PTO, check with legal counsel on how to avoid constructive receipt.