Tax Treatment When Employees Surrender Paid Time Off to Benefit Others

Editor: Greg A. Fairbanks, J.D., LL.M.

Employee Benefits & Pensions

Hurricane Sandy had a devastating effect on many employees throughout the Northeast, causing them to miss work for a prolonged period. The days needed by some of these employees to focus on their personal lives rather than work outnumbered the days they had accrued as paid time off (PTO). As a result, these employees faced going without pay while they tried to recover from the natural disaster. Recognizing the hardships that these employees were facing, some employers implemented leave-sharing programs to allow employees to help fellow employees in need. Other employers throughout the nation implemented plans to allow employees to donate the value of their accrued PTO to charitable organizations assisting in disaster relief.

There are various types of PTO donation and leave-sharing programs, not all of which are disaster-related. The tax treatment to the donating employee differs based on the type of program. This item explores the tax treatment of various programs, including special rules that apply to certain PTO charitable donation programs and leave-sharing programs that benefit employees who are affected by a disaster, such as victims of Hurricane Sandy.

Standard PTO Charitable Donation Program

Employers may establish a program that allows employees to donate the value of a certain number of hours or days of PTO to a charitable organization. The employer gives cash to the charitable organization equal to the value of the donated PTO.

As unlikely as it may sound, except in certain circumstances described below, donating PTO generally results in a taxable event for the donating employee. Under the assignment-of-income doctrine, the donating employee is generally required to recognize compensation income equal to the value of the donated PTO. Various cases have established the assignment-of-income doctrine. In Rev. Rul. 72-542, the IRS explained how the doctrine applies to payments for personal services that are directed to a charitable organization:

It is a fundamental concept in tax law that there is realization of income to the person who has the right to receive it or the power to dispose of it, and payment directly to an exempt organization, at the direction of the person whose individual personal services earned it, constitutes an assignment of income that is disregarded for Federal income tax purposes.

Simply put, an individual cannot give a vested valuable right to another person without first recognizing taxable income equal to the value of that right.

Example: F donates the value of 20 hours of PTO to a charitable organization through a PTO charitable donation program established by his employer. F earns $30 per hour, so the value of his donated PTO is $600. F will recognize $600 of compensation income when he elects to donate the PTO.

The income recognized by F must be reported to him on a Form W-2, Wage and Tax Statement, and is subject to income tax withholding, as well as Federal Insurance Contributions Act (FICA) tax withholding (i.e., Social Security and Medicare taxes). This warrants special consideration, since normally, an employer withholds these taxes from cash payments made to the employee. However, F does not receive a cash payment when he donates the PTO, but his employer must still obtain the withholding taxes from F (typically by withholding from F’s normal wages), resulting in less after-tax cash for F.

Consider how F’s donation affects his take-home pay: F is paid weekly. He works 40 hours a week, so his gross pay for the week is $1,200 ($30 per hour × 40 hours). Assume the amount normally withheld from his pay for federal and state income taxes and FICA tax is $300, so his take-home pay is $900. In the week he donates the PTO, he recognizes an additional $600 of income, but he does not receive it as cash. Assume that as a result of this additional income that must be recognized, the amount of federal and state income taxes and FICA tax that must be withheld from his pay increases from $300 to $500. If F’s employer withholds this extra amount from his normal wages, F’s take-home pay will decrease from $900 to $700. F will probably not be happy that his employer reduced his paycheck as a result of his kindness.

Employers can consider paying the additional income and FICA tax on behalf of the employee. This can be accomplished by grossing up pay so that the employee’s after-tax pay is the same as for other payroll periods. Obviously, this will cost the employer money, which would not be attractive to the employer. As an alternative, employers can consider reducing the cash payment they make to the charity by the amount of the tax withholding. For example, F’s additional withholding taxes are $200. His employer could reduce the cash paid to the charity from $600 to $400, and use the $200 to pay F’s taxes. This results in F’s donating the after-tax value of the PTO rather than its pretax value.

Regardless of the method by which the employer withholds the appropriate amount of income taxes and FICA taxes, it should notify employees about its obligation and method for withholding taxes before employees donate PTO.

Because the value of the PTO is donated to a charitable organization, the donor employee is allowed a charitable contribution deduction under Sec. 170. The employer should submit the cash payment to the charitable organization on behalf of the donor employee so the organization can provide the employee with the proper documentation to substantiate his or her charitable contribution.

Other than the employer’s reporting and withholding obligations, the standard PTO charitable donation program will have little effect on the employer’s taxes. The employer is allowed an income tax deduction for the value of the PTO donated by the employee, under Sec. 162 as compensation expense, rather than as a charitable contribution.

The PTO donation program does not affect employees who have accrued PTO they could have donated but who do not elect to participate in the program because the doctrine of constructive receipt does not apply. In general, if money is set aside so an employee can draw upon it at any time or direct its use, the employee is in constructive receipt of the money and must recognize it as income even if the employee does not receive the payment. This raises concerns with a PTO charitable donation program because the employee can choose to donate the value of his or her accrued PTO, which as discussed above, results in income recognition by the employee. On its face, this appears to result in constructive receipt.

However, in Letter Ruling 200601005, the IRS ruled that employees who do not participate in a PTO charitable donation program are not in constructive receipt of the value they could have donated if they had participated. The IRS does not provide the rationale for its conclusion, but it appears that constructive receipt does not apply because an employee’s PTO includes a valuable future right. In Rev. Rul. 80-300, the IRS ruled that an individual was not in constructive receipt of the intrinsic value of a stock appreciation right that he or she could exercise at any time, because the individual’s right to benefit from future appreciation of stock without risking any capital was a valuable right. The employee’s PTO appears to be a valuable right for several reasons, including that (1) the value of the PTO increases as the employee’s pay increases in the future, and (2) the employee can use that PTO for future days off from work.

The standard PTO charitable donation program is beneficial because it allows an employee to convert unused or unwanted PTO into cash payments to a charitable organization. However, employees must be aware of the tax consequences, and it is best that employees understand this before they decide to donate the value of PTO.

Disaster Relief PTO Charitable Donation Programs

In certain situations, the IRS has waived the assignment-of-income doctrine rules discussed above that require employees to recognize compensation income when they donate the value of PTO to a charitable organization for disaster relief. The most recent of these situations is the aftermath of Hurricane Sandy. In Notice 2012-69, the IRS provided that employees who surrender unused PTO under a program in which the employer contributes the value of the PTO before Jan. 1, 2014, to a Sec. 170(c) charitable organization for the relief of victims of Hurricane Sandy will not be required to recognize compensation income for the value of the surrendered PTO. Organizations described in Sec. 170(c) include corporations, trusts, community chests, funds, or foundations organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes.

Because the value of the surrendered PTO is not includible in the employee’s income, the employer is not required to report the value on the employee’s Form W-2 or withhold federal income taxes or FICA taxes. As with the standard PTO charitable donation program, the employer can take a compensation deduction under Sec. 162 for the value of the PTO contributed to the charitable organization. However, unlike the standard PTO donation program, the disaster-relief program does not allow the employee to take a charitable contribution deduction because the employee is not required to include the value in income.

This treatment does not apply to all federally declared disasters. The IRS has chosen to make it available only for certain disasters: Hurricane Sandy, Hurricane Katrina in 2005 (Notice 2005-68), and the Sept. 11, 2001, terrorist attacks (Notice 2001-69).

Standard Leave-Sharing Banks to Benefit Fellow Employees

Another type of program that an employer may establish is a standard leave-sharing bank for use by employees. With a leave-sharing bank, an employee surrenders a certain amount of unused accrued PTO, which the employer places in the leave-sharing bank. Other employees who have run out of PTO can then use the leave-sharing bank for reasons specified by the employer.

Employers that implement a leave-sharing bank should consider using a process that requires the employee to provide an application to the employer specifying the reason for his or her extended absence from work and the need for additional PTO. After the employer approves the application, it can provide additional PTO to the recipient employee, which may include payments for time off while the application was being approved. Employers may consider limiting the amount of additional PTO that the recipient employee may receive so that the leave-sharing bank is not exhausted and is available for other employees.

As with the standard PTO charitable donation program, the employee who surrenders the PTO is required to recognize compensation income under the assignment-of-income doctrine equal to the value of the surrendered PTO. The employer is required to report this compensation on the donor employee’s Form W-2 and withhold the appropriate income taxes and FICA tax. A leave-sharing bank poses the same issues concerning the method of withholding the applicable taxes as the standard PTO charitable donation program.

Unlike the standard PTO charitable donation program discussed above, the standard leave-sharing bank does not entitle the donating employee to a charitable contribution deduction because the employee does not make a contribution to a charitable organization.

Major Disaster Leave-Sharing Plan

A major disaster leave-sharing plan operates similarly to a standard leave-sharing bank, but the leave accumulated in the bank is used only by employees adversely affected by any presidentially declared major disaster. An employer establishes a major disaster leave-sharing plan in the wake of a major disaster to allow employees to surrender unused PTO for use by fellow employees whom the disaster affected. President Barack Obama declared Hurricane Sandy a major disaster.

If the plan is in writing and meets certain conditions set forth in Notice 2006-59, the donating employee is not required to recognize compensation income for the value donated to the plan. This means the employer is not required to report the value on a Form W-2 or withhold income tax or FICA tax from the donating employee’s compensation. Because the donating employee does not recognize compensation and because the donation is not made to a charitable organization, he or she is not allowed a charitable contribution deduction for the value of the donated PTO.

An employee who receives payments from the major disaster leave-sharing program is required to recognize income equal to the amount of the payment he or she receives. This payment is treated as compensation, so the employer must report the compensation on the recipient employee’s Form W-2 and withhold the appropriate income taxes and FICA taxes. The employer is allowed a tax deduction under Sec. 162 for the payments made from the plan at the time the payments are made to the recipient employee, not when the donor employee surrenders the PTO.

As mentioned above, the major disaster leave-sharing plan must meet certain conditions specified in Notice 2006-59 for the favorable tax treatment to apply to the donating employee:

• The leave-sharing plan is for employees who have been adversely affected by a major disaster, as declared by the president. An employee is adversely affected if the disaster has caused severe hardship to the employee or a family member that requires the employee to be absent from work.
• An employee who donates PTO cannot designate its use by a specific employee.
• An employee may not donate more PTO in a given year than he or she normally accrues for the year.
• A PTO recipient may receive PTO at his or her normal rate of compensation.
• A PTO recipient must use the PTO for purposes related to the major disaster.
• The plan must adopt a reasonable limit on how long after the disaster PTO deposits may be made to the plan and PTO may be used by recipients. The period must be based on the severity of the disaster.
• A PTO recipient may not convert PTO received under the plan into cash in lieu of using it.
• The employer must make a reasonable determination, based on need, as to how much PTO each approved PTO recipient may receive under the plan.
• PTO deposited on account of one disaster may be used only for employees affected by that disaster.

Any PTO deposited that is not used by PTO recipients must be returned within a reasonable period to the donor employees so that the donor will be able to use the PTO. An exception to this rule is made for amounts so small as to make accounting for them unreasonable or administratively impracticable. Employers may choose to return the PTO only to donor employees who are still employed by the employer. The amount of PTO returned to each donor employee must be in the same proportion as the amount of PTO surrendered by the donor employee bears to the total amount of PTO surrendered on account of the disaster.

The list of conditions that a major disaster leave-sharing plan must meet is long, but the benefit to the PTO recipients will most likely outweigh the administrative burden of establishing and maintaining a compliant plan.

Medical Emergency Leave-Sharing Plan

A medical emergency leave-sharing plan is another type of leave-sharing bank that allows an employee to surrender unused PTO without recognizing compensation income. A medical emergency leave-sharing plan is similar to a standard leave-sharing bank, but the leave accumulated in the bank is available only to employees with medical emergencies.

In Rev. Rul. 90-29, the IRS ruled that as long as certain conditions are met, an employee who surrenders PTO to a medical emergency leave-sharing plan is not required to recognize compensation income for the value of the surrendered PTO. As a result, the employer is not required to report the value of the PTO on the donor employee’s Form W-2 or withhold income tax or FICA tax from the donor employee’s compensation. As with the major disaster leave-sharing plan, the donor employee cannot take a charitable contribution deduction.

An employee who receives the additional PTO from the medical emergency leave-sharing plan is required to include the payments in income, and the employer is required to report the payments on the recipient employee’s Form W-2 and withhold income tax and FICA tax from the payments. The employer can take a tax deduction under Sec. 162 for the payments made from the plan at the time it makes the payments to the recipient employee, not when the donor employee surrenders the PTO (Regs. Sec. 1.461-1).

For this purpose, a “medical emergency” is a medical condition of the employee or a family member of the employee that will require the prolonged absence of the employee from duty and will result in a substantial loss of income to the employee because the employee will have exhausted all PTO available apart from the leave-sharing plan. In Letter Ruling 200720017, the IRS approved a plan in which a prolonged absence included intermittent absences related to the same condition or illness.

The plan must require the recipient employee to submit to the employer a written application describing the medical emergency. Additional paid leave may be granted to the employee under the plan only after the employer has approved the written application and the employee has exhausted all of his or her accrued PTO. The plan must contain restrictions on the amount of PTO that may be surrendered by the donor employee and contain rules for how the surrendered PTO will be granted to eligible PTO recipients.

Conclusion

Employers may establish various PTO charitable donation and leave-sharing programs to allow employees to help those in need. Some, such as a standard PTO charitable donation program and a standard leave-sharing bank, allow employees to donate or share PTO, but the assignment-of-income doctrine requires them to recognize compensation income equal to the value of the surrendered PTO. This can create problems for employers and employees in withholding the applicable income tax and FICA tax, so employers should implement a method for withholding or paying the taxes and make the employees aware of the withholding obligation. Other programs are much more tax-friendly for the donor employee but are available only for certain situations, such as major disasters and medical emergencies. Whether they choose a standard program or a more taxpayer-friendly one, employers may consider implementing such a program to benefit employees and other individuals in need.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.