Employers that convert or pay out certain leave benefits may be stuck with unexpected tax results or even commit violations of the tax code, according to a July 9, 2013 tax compliance newsletter for federal, state, and local government employers issued by the Internal Revenue Service (“IRS”). The newsletter’s lead article serves to remind governmental employers of its long-held position that certain leave conversion benefit plan features may result in unexpected tax treatment and violations. Specifically, if an employee is allowed the option of receiving the benefit in cash or as another form of benefit, an otherwise tax-free benefit could be inadvertently converted into a taxable benefit.
The recent IRS article highlights the issue of the form in which a sick leave benefit may be paid out. It is worth noting that this differs from the separate question of whether accrued sick leave must be paid out, once the benefit is promised. On that issue, the Wisconsin Supreme Court’s 2005 ruling in Champine v. Milwaukee County, and Wisconsin Court of Appeals’ June 18, 2013 determinations in Pasko v. Milwaukee County, Porth v. Milwaukee County, have made clear that, once accrued, sick leave payout benefits may not generally be reduced.
With respect to the risks inherent in offering an employee a choice regarding the form of sick leave payment, public sector employers who offer leave conversion benefits, or who are considering implementing or amending such programs, should carefully review the specific benefit design in order to ensure compliance with the tax rules recently highlighted by the IRS.
Leave Payout Plans, Generally
A leave payout plan is a plan that allows an employee to receive the value of accrued but unused vacation or a specified value for accumulated sick leave at a specified time or upon retirement.
When the payment for an unused leave benefit is made in cash, the amounts are taxable to the employee. A lump sum cash payment of the total accrued leave upon retirement is generally a straightforward benefit transaction with little risk of tax violations.
Mandatory Benefit Conversion
In order to provide greater retirement savings or health benefits to retirees, many employers require the accrued but unused leave to be converted, upon retirement, into additional retirement benefits, such as a contribution to an employer-sponsored savings plan (for example, a 403(b) or 457(b) account), or to be applied toward the cost of various post-employment medical benefits.
Option between Cash or Other Benefit Conversion
Still other employers allow the retiring employee to choose whether the payment for accrued, but unused leave will be provided in the form of cash or as an additional retirement benefit.
IRS Income Recognition Rules
Because cash payment is always taxable and because retirement savings and health benefits are generally tax-free to the participant, when an employer offers a choice as to the form of unused leave payment, they are effectively offering a choice between a taxable and a non-taxable benefit. The choice creates an unintended tax consequence thereby converting the tax-free health benefit into a taxable benefit, just like the cash option.
The principle underlying the IRS’s position is the doctrine of “constructive receipt,” or the default rule that any form of compensation is taxable to an employee from the moment that it is made available to the employee without substantial limitations. According to the IRS, the employee’s ability to elect to receive a benefit in cash demonstrates that the employee has full control over the benefit, and should, therefore, pay taxes on it immediately, regardless of whether the employee decides to defer actual receipt of the benefit until a later time.
The failure of the employer and the employee to withhold and report taxes with regard to the additional retirement benefit option exposes both the employer and the employee to an IRS enforcement action for payment of the proper taxes as well as for related penalties and interest.
The existence of a properly drafted and administered Section 125 Plan (or “Cafeteria Plan”) provides an exception to the constructive receipt rules, and generally allows an employee to make a choice between a cash payment and a non-taxable benefit. Under some circumstances, therefore, an employer may be able to process a leave conversion plan through a valid Cafeteria Plan. Given certain restrictions that apply under the Cafeteria Plan rules, it may be simpler, depending on all of the facts, to provide the benefit completely outside of a Cafeteria Plan.
In any event, tax law and IRS guidance is clear; where the value of accrued but unused leave benefit is either (1) converted on a mandatory basis (with no employee option) into another form of benefit; or (2) properly offered and administered through a Cafeteria Plan, the doctrine of constructive receipt will not cause the taxation of the benefit.
Separate and apart from the doctrine of constructive receipt, the opportunity to choose a cash payment instead of a non-taxable benefit expressly violates the tax rules applicable to certain benefits. For example, a Health Reimbursement Arrangement (“HRA”) will cease to be a tax-favored arrangement if an employee has the option to choose payment in cash at any time. Similarly, payment of accrued, but unused leave may generally not be converted to a 403(b) or Tax Sheltered Annuity (“TSA”) benefit at the employee’s option. In order to maintain the tax-deferred nature of these benefits, they may only be provided as a mandatory benefit and not as one option presented to the employee.
The IRS’s selection of this topic for its recent governmental employer newsletter may indicate that the agency audits have revealed a relatively high rate of noncompliance, and that the structure of leave payout programs will be receiving increased examination scrutiny in the near term.
Whether or not employees may be offered a choice as to the form in which benefits are received varies according to the type of benefit involved, and in light of all of the specific circumstances. With respect to the payment of accrued, but unused sick leave, however, employers must understand that a choice between cash or another form of benefit will always be problematic, unless a Cafeteria Plan (or another exception) properly applies.
If you have any questions regarding this article, please contact your Davis & Kuelthau attorney.