IRS Clarifies Rule for Contributing Unused Paid Time Off to Sec. 401(k) Plans

The IRS has issued Rev. Ruls. 2009-31 and 2009-32 to clarify issues involving the contribution of the dollar value of unused paid time off (PTO) to the employer’s Sec. 401(k) plan. Rev. Rul. 2009-31 addresses two situations for continuing employees in which the employee either has no election or has an election. In both cases the unused PTO may be contributed to the qualified plan, but the tax treatment differs. Rev. Rul. 2009-32 addresses the same two situations for terminating employees. The affected year differs depending on whether the employee terminates on October 1 or December 28 because contribution to the Sec. 401(k) plan occurs roughly two weeks after the termination of employment.

Rev. Rul. 2009-31: Active Employees

Situation 1—No employee election: Company Z provides 240 hours of PTO each calendar year. Employees may not carry over unused PTO to the next year. Z amends its PTO and Sec. 401(k) plans to provide that on December 31, any unused PTO is forfeited and the dollar equivalent of that unused PTO is contributed to the Sec. 401(k) plan (and allocated to the participant’s account as of that same December 31). The contribution is capped by the maximum contribution under Sec. 415 for the year (e.g., $49,000 for 2009). Z pays any amount above the permissible Sec. 415 contribution for that employee to the employee by the following February 28.

Because the employee had no election, the contribution is treated as Z’s nonelective contribution to the plan for the year in which the December 31 forfeiture and contribution take place. Because the dollar equivalent is not paid, set apart, or otherwise made available so the participant can draw on it, the IRS provides that under the doctrine of constructive receipt and Sec. 451, the amount is not includible in the participant’s gross income in the year of conversion. An amendment allowing this treatment does not violate the plan qualification rules as long as this contribution (along with other employer contributions) is nondiscriminatory. In addition, the amendment does not make the PTO plan fail to be a bona fide sick and vacation leave plan for purposes of Sec. 409A.

Situation 2—Employee election: In the second situation, the IRS changes the facts so that Company Y has a PTO plan that allows the employee to carry over to the next year (the carryover limit) some of the unused PTO. Y pays any unused PTO above the carryover limit to the employee by February 28 of the following year. Y amends its PTO and Sec. 401(k) plans to allow participants to elect to reduce all or part of the dollar equivalent of any unused PTO above the carryover limit (i.e., the portion they would otherwise receive in cash) and contribute it to the Sec. 401(k) plan. Y makes the contribution to the Sec. 401(k) plan on February 1 of the following year and does not retroactively allocate it. The employee will receive in cash by February 28 of the following year any amount he or she does not elect to contribute to the Sec. 401(k) plan.

Rev. Rul. 2009-31 provides that if the participant makes a valid and timely election, the contribution to the plan is treated as an elective contribution. The analysis emphasizes that the fact pattern provides that the employee may not carry over to the following year the dollar value of the unused PTO greater than the carryover limit (even though the plan has until February 28 of the following year to pay it). For purposes of the limits governing Sec. 401(k) plans (i.e., the $16,500 and related limits) and defined contribution plans (e.g., the $49,000 defined contribution limit), the allocation is treated as occurring in that following year because under the facts it is allocated as of that date. As with Situation 1, there is no constructive receipt or gross income under Sec. 451, and the PTO plan remains a bona fide sick and vacation leave plan for purposes of Sec. 409A.

Rev. Rul. 2009-32: Employment Terminations

Situation 1—No employee election (October 1 employment termination): The PTO and Sec. 401(k) plans are similar to those in situation 1 of Rev. Rul. 2009-31. There is a carryover limit for unused PTO, and any amount in excess of the carryover limit is forfeited. An employee who terminates in the middle of the year receives the dollar equivalent of his or her unused PTO at the time of employment termination up to the carryover limit.

Company W amends the plan to provide that the dollar value of a terminated employee’s unused PTO (up to the carryover limit) is forfeited under the PTO plan. It is contributed to the Sec. 401(k) plan and allocated as of the first day of the second pay period beginning immediately after plan termination. Under the facts, the employee leaves on October 1, and the dollar equivalent of the unused PTO is contributed and allocated as of October 19.

Rev. Rul. 2009-32 treats the amount contributed as a nonelective employer contribution, and the contribution is tested for nondiscrimination as such. The revenue ruling warns that because the amount of the contribution for each participant varies by the dollar value of the participant’s unused PTO, the plan is unlikely to satisfy a design-based nondiscrimination safe harbor.

Situation 2—No employee election (December 28 employment termination): The facts are the same as in Rev. Rul. 2009-32, situation 1, but the employee’s termination occurs on December 28 instead of October 1. Company W makes the contribution on January 18 of the following year. The contribution is also allocated as of that date and is treated for all purposes as a contribution and allocation for that following year. Situations 1 and 2 differ in result only by the relevant year—the year of termination in situation 1 and the following year in situation 2.

Situation 3—Employee election (October 1 employment termination): Situation 3 is similar to situation 2 of Rev. Rul. 2009-31 (i.e., the amendment creates an employee election between cash or a contribution to the Sec. 401(k) plan). Thus, the contribution will be an employee elective contribution. Here the employee termination takes place on October 1, so the elective contributions are treated as such in the year of employment termination.

Situation 4—Employee election (December 28 employment termination): Situation 4 involves an employee election as in situation 3 and a December 28 termination as in situation 2 of Rev. Rul. 2009- 32. The relevant year for all purposes is the year following the year of termination because that is when the contribution and allocation take place.

Implications

Employers with PTO programs have struggled with the design and tax issues that arise when the employer wants to allow some (or all) of the dollar equivalent of unused PTO to be an automatic or elective contribution to the Sec. 401(k) plan. These revenue rulings are intended to encourage such plan designs by providing favorable tax interpretations. These revenue rulings are two in a series of IRS rulings and notices that President Obama announced on September 5, 2009. In a press release, Treasury Secretary Timothy Geithner announced that these steps “make it easier for working families to save, particularly for retirement” (www.treas.gov/press/releases/tg276.htm). Most of the issuances (but not these) focus on making it easier for employers to provide for automatic enrollment in their Sec. 401(k) (and similar) plans. The theory behind automatic enrollment is that workers are more likely to save part of their salary if they have to elect out of automatically saving rather than having to elect in to saving. These initiatives do not require legislation and are separate from the administration’s push for legislation providing for payroll IRAs.

EditorNotes

David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

For additional information about these items, contact Mike Dell at (202) 327-8788 or michael.dell@ey.com.