McKay Hochman Company, Inc.

The IRS released two Revenue Rulings on September 5, 2009, both of which addressed the process of applying the dollar value of a participant’s unused paid time off (PTO) as a contribution to a qualified pension, profit sharing, or stock bonus plan. RR 2009-31 for active participants, while RR 2009-32 is for a terminated employee. Below are highlights of each Ruling.

Rev. Rul. 2009-31 Contribution of Unused Paid Time Off (PTO) for Active Employees
This Ruling described two employer options for contributing the dollar-equivalent of unused PTO into a plan for active participants:

If an employer does not allow an employee the option to receive the value of their unused PTO as taxable income, the employer may contribute the value of the PTO into the plan as a non-elective contribution if plan language permits. Pre-approved EGTRRA plans do not currently provide for this type of allocation, so at this time it appears this option would only be permitted in an individually designed plan. Note that if any HCES receive this type of non-elective contribution, the plan must use the general test for Section 401(a)(4) nondiscrimination testing as the safe harbor uniformity requirements would not be satisfied. The employer may wish to exclude HCEs from this allocation to avoid failing nondiscrimination testing.

The Ruling clarifies that if an employer permits an employee to receive unused PTO as additional income, the employee may elect to contribute these amounts into the plan as an elective deferral. Any amount treated as an elective deferral will be subject to the Sec. 402(g) limit and the Sec. 415 annual addition limits.

Rev. Rul. 2009-32 Contribution of Unused Paid Time Off (PTO) for Terminated Employees
On the Sec. 415 amendment, employers have the ability to exclude unused paid time off from the definition of eligible plan compensation after severance. If this is selected, the participant will be required to receive the value of their unused PTO as a cash payment and will not be entitled to defer any of it to a 401(k) plan, assuming the employer offers the employee payment rather than forfeiting the amount.

An employer may treat unused PTO for terminated employees in the same manner as in Rev. Rul. 2009-31. However, it differentiates a terminated participant receiving the PTO in the current year from one receiving it in the following year.

If an individual terminates in 2009 and receives the value of their unused PTO in 2009 as either a non-elective contribution or as an elective deferral in 2009, these amounts will apply to the 2009 limitation year.

However, if a participant terminates close to the end of a year and receives their unused PTO amounts in the following year, there could be Sec. 415 issues. If a participant who terminated in December 2009 has the entire PTO contributed as a NEC in January or February 2010, there will be a annual additions failure because the individual has no compensation in 2010. The solution is to limit the NEC to half of the unused PTO.

Example
Employee terminated 12/1/08 and has accrued $500 in unused PTO, which is due to be received 1/15/09. The plan treats unused PTO as non-elective contributions. Under the 50% rule, the employer pays 50% of the PTO to the employee and contributes 50% as a NEC. Thus, the Sec. 415 annual additions test is met as the employee received $250 in compensation and the NEC was $250 (100% of the 415 limit).

In both of these Rulings the IRS confirmed that contributions made into a plan based on the values of unused PTO will not be included in the gross income of a participant until the money is distributed from the plan.

Note that the Ruling does not address FICA (on deferrals), withholding or state law issues. Some state laws require payment of wages and thus, the NEC may be a problem in those states. The employer needs to consider all these facets before deciding to offer the PTO option.

To learn more, call 973-492-1880 or e-mail info@mhco.com.