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Paid time off plans: IRS guidelines and why they matter

11.28.16

Are you spending enough time on your paid time off plan?
Many questions arise regarding paid time off (PTO) plans and the constructive receipt of income, which can cause payroll complications for employers and phantom income inclusion for employees. In order to avoid being subject to penalties for not withholding income and payroll taxes and having employees be subject to tax on cash they have not received, certain steps need be followed if an employer wants to properly allow employees to cash-out PTO.

What the IRS is looking for.
The Internal Revenue Service (IRS) has issued a number of Private Letter Rulings (PLRs) that examine earned time cash-out programs. While such rulings don’t serve as precedent, it appears the IRS has come up with the following factors that it deems important in order to avoid constructive receipt in a PTO cash-out situation:

  1. Employees must make a written election before the end of December in the year prior to the year they will be earning and receiving the accrued earned time to be cashed-out.  This is an election to receive a cash payout of the earned time to be accrued in the following year.
  2. The election must be irrevocable.
  3. The payout can only happen once the employee has actually earned and accrued the earned time in the following year. Payouts are generally once or twice per year, but may happen more frequently.

The IRS appears to generally require that the earned time being paid out be substantially less than the accrued earned time owed to the employee. This is to ensure that the earned time program remains a bona fide sick or vacation pay plan and not a plan of deferred compensation. This particular requirement can get tricky and may be different in each employer’s case.

Why does it matter?
The danger of failing to follow IRS guidelines regarding earned time cash-outs is that the IRS could claim that the employees offered a choice to cash-out are in constructive receipt of their accrued earned time balances regardless of their choice. This would result in immediate taxation of all accrued amounts to the employees, even if they hadn’t received the cash. The employer would also be subject to penalties for not properly withholding federal and state taxes.

It is important to review your PTO plan to be sure there are no issues regarding constructive receipt and to make sure your payroll systems are correctly reporting income.

The IRS issued proposed regulations under Code Section 457 in June of 2016 regarding, in part, non-qualified deferred compensation plans of not-for-profit (NFP) organizations. Those regulations contain guidance regarding the cash-out of sick and vacation time and the possibility that certain cash-out provisions may create a plan of deferred compensation and not a bona fide sick leave or vacation leave plan. As noted above, such a determination would be disastrous as all amounts accrued would become immediately taxable. NFP organizations and their advisors should keep a close eye on the proposed Section 457 regulations to see how they develop in final form. Once the regulations are finalized, NFP organizations may need to make changes to their cash-out provisions.

Please note that the above information is general in nature and is not meant to provide guidance on any particular case. If you have any questions about your PTO plan, please contact Bill Enck.

Related Services

When it comes to offering non-qualified deferred compensation to executives of not-for-profit organizations, there aren’t many options. Your organization must follow the rules and related guidance outlined in Internal Revenue Code Sections 457 and 409A. There are two types of non-qualified deferred compensation plans: Eligible (457(b) plans) and ineligible (457(f) plans)

  • 457(b) plans operate very similarly to 403(b) or 401(k) plans and have an annual benefit limit.
  • 457(f) plans have no annual benefit limit but the participants must include the benefits in taxable income when the substantial risk of forfeiture lapses.

Changes are on the table
And that's largely a good thing.The proposed regulations provide guidance in several key areas used to determine whether a substantial risk of forfeiture exists or not. For the most part, the proposed guidance is welcome news and provides an employer with more flexibility than originally expected.

Earlier this year, the IRS issued proposed regulations which describe just what constitutes a substantial risk of forfeiture under an ineligible 457(f) plan and what types of benefits are not considered to be ineligible 457(f) plans. Because of the tax implications to the executive, this is important for your organization to understand and communicate.

What the proposed regulations cover:

  1. Non-compete agreements
  2. Rolling risks of forfeiture (e.g., rolling vesting schedules)
  3. Determining the present value of accrued benefits
  4. Plans that are not considered 457(f) plans, including bona fide severance pay plans

In each of these areas, the proposed regulations provide employers with specific rules to follow in order to design and operate a plan, whether it's an existing plan or one adopted before or after the rules are finalized. Current plans will not have grandfathered status. 

What you need to do
For existing deferred compensation arrangements or employment contracts that provide for severance pay for deferred compensation arrangements,you must:

  • Take inventory of the types of benefits you provide (e.g., severance pay, 457(b), 457(f) plans)
  • Review plan provisions and determine the changes you need to make in order for them to be in compliance with the guidelines. 
  • Make the appropriate changes to the plan or employment contract provisions before the final regulations are effective.
  • The final regulations generally will not be effective until 90 days after they've been published. You may rely on them in the interim.

If you have questions or concerns
We've helped many not-for-profit organizations design and develop executive compensation packages, including deferred compensation plans. Our Benefits Compensation experts are well versed in the rules that apply to deferred compensation and severance pay plans and can help guide you through the process to:

  1. Create a plan that meets the needs of your executive and your organization
  2. Determine if any changes must be made to the benefits you’re currently offering

Contact Bill Enck if you have questions or need help.

Blog
Do you sponsor a 457(f) plan? If so, keep reading!

The IRS announced plans to conduct examinations of the universal availability requirements for 403(b) plans (Plans) this summer. Noncompliance with these requirements results in operational errors for Plans―ultimately requiring correction. Plan sponsors should review their Plans for proper inclusion and exclusion of employees. Such review can help you avoid costly penalties if the IRS does conduct an examination and uncovers an issue with the Plan’s implementation of universal availability.

Universal availability requires that, if you permit one employee to make elective deferrals into a 403(b) plan, then all other employees must receive the same opportunity. There are a few exceptions to this rule. Plan sponsors may exclude employees who meet one of the following exceptions:

  • Employees who will contribute $200 annually or less
  • Employees eligible to participate in a § 401(k), 457(b), or other 403(b) plan of the same employer
  • Employees who normally work less than 20 hours per week (the equivalent of less than 1,000 hours in a year)
  • Students performing services described in Internal Revenue Code § 3121(b)(10)

Of these exceptions, errors in applying the universal availability requirements are typically found with the less than 20 hours per week exception. Even if an employee works less than 20 hours per week (essentially a part-time employee), if this employee works 1,000 hours or more, you must allow this employee to make elective deferrals into the Plan. Further, you can’t revoke this permission in subsequent years―once the employee meets the 1,000 hour requirement, they are no longer included in the less than 20 hours per week employee class.

We recommend Plan sponsors review their Plan documents to ensure they are appropriately applying elected eligibility provisions. Further, we recommend Plan sponsors annually review an employee census to ensure those exceptions (listed above) remain appropriate for any employees excluded from the Plan. For instance, if you note that an employee worked 1,000 hours during the year, who was being excluded as part of the “less than 20 hours per week” category, you should ensure you notify this employee of their eligibility to participate in the Plan. In addition, you should retain documentation regarding the employee’s deferral election or election to opt out of the Plan. Such practices will help ensure, if your Plan is selected for IRS examination, it passes with no issues.

For more information: https://www.irs.gov/retirement-plans/403b-plan-fix-it-guide-you-didnt-give-all-employees-of-the-organization-the-opportunity-to-make-a-salary-deferral
 

Blog
Not the summer of love: IRS universal availability examinations

This blog is the first in a series to help employee benefit plan fiduciaries better understand their responsibilities and manage the risks of non-compliance with ERISA requirements.

On Labor Day, 1974, President Gerald Ford signed the Employee Retirement Income Security Act, commonly known as ERISA, into law. Prior to ERISA, employee pensions had scant protections under the law, a problem made clear when the Studebaker automobile company closed its South Bend, Indiana production plant in 1963. Upon the plant’s closing, some 4,000 employees—whose average age was 52 and average length of service with the company was 23 years—received approximately 15 cents for each dollar of benefit they were owed. Nearly 3,000 additional employees, all of whom had less than 10 years of service with the company, received nothing.

A decade later, ERISA established statutory requirements to preserve and protect the rights of employees to their pensions upon retirement. Among other things, ERISA defines what a plan fiduciary is and sets standards for their conduct.

Who is—and who isn’t—a plan fiduciary?
ERISA defines a fiduciary as a person who:

  1. Exercises discretionary authority or control over the management of an employee benefit plan or the disposition of its assets,
  2. Gives investment advice about plan funds or property for a fee or compensation or has the authority to do so,
  3. Has discretionary authority or responsibility in plan administration, or
  4. Is designated by a named fiduciary to carry out fiduciary responsibility. (ERISA requires the naming of one or more fiduciaries to be responsible for managing the plan's administration, usually a plan administrator or administrative committee, though the plan administrator may engage others to perform some administrative duties).

If you’re still unsure about exactly who is and isn’t a plan fiduciary, don’t worry, you’re not alone. Disagreements over whether or not a person acting in a certain capacity and in a specific situation is a fiduciary have sometimes required legal proceedings to resolve them. Here are some real-world examples.

Employers who maintain employee benefit plans are typically considered fiduciaries by virtue of being named fiduciaries or by acting as a functional fiduciary. Accordingly, employer decisions on how to execute the intent of the plan are subject to ERISA’s fiduciary standards.

Similarly, based on case law, lawyers and consultants who effectually manage an employee benefit plan are also generally considered fiduciaries.

A person or company that performs purely administrative duties within the framework, rules, and procedures established by others is not a fiduciary. Examples of such duties include collecting contributions, maintaining participants' service and employment records, calculating benefits, processing claims, and preparing government reports and employee communications.

What are a fiduciary’s responsibilities?
ERISA requires fiduciaries to discharge their duties solely in the interest of plan participants and beneficiaries, and for the exclusive purpose of providing benefits for them and defraying reasonable plan administrative expenses. Specifically, fiduciaries must perform their duties as follows:

  1. With the care, skill, prudence, and diligence of a prudent person under the circumstances;
  2. In accordance with plan documents and instruments, insofar as they are consistent with the provisions of ERISA; and
  3. By diversifying plan investments so as to minimize risk of loss under the circumstances, unless it is clearly prudent not to do so.

A fiduciary is personally liable to the plan for losses resulting from a breach of their fiduciary responsibility, and must restore to the plan any profits realized on misuse of plan assets. Not only is a fiduciary liable for their own breaches, but also if they have knowledge of another fiduciary's breach and either conceals it or does not make reasonable efforts to remedy it.

ERISA provides for a mandatory civil penalty against a fiduciary who breaches a fiduciary responsibility under ERISA or commits a violation, or against any other person who knowingly participates in such breach or violation. That penalty is equal to 20 percent of the "applicable recovery amount" paid pursuant to any settlement agreement with ERISA or ordered by a court to be paid in a judicial proceeding instituted by ERISA.

ERISA also permits a civil action to be brought by a participant, beneficiary, or other fiduciary against a fiduciary for a breach of duty. ERISA allows participants to bring suit to recover losses from fiduciary breaches that impair the value of the plan assets held in their individual accounts, even if the financial solvency of the entire plan is not threatened by the alleged fiduciary breach. Courts may require other appropriate relief, including removal of the fiduciary.

Over the coming months, we’ll share a series of blogs for employee benefit plan fiduciaries, covering everything from common terminology to best practices for plan documentation, suggestions for navigating fiduciary risks, and more.

Blog
What's in a name? A lot, if you manage a benefit plan.

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