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cash outs of accumulated vacation pay


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A Tax exempt employer allows all employees to accumulate unused vacation pay. Employees may cash out up to 25% of unused days in any calendar year. When the employer has extra staffing needs, it allows them to cash out the entire bank. When employees retire, they are cashed out.

Obvious 457(f) issue is the cash-out. At what point is this vested deferred compensation? The annual vacation schedules are negotiated with a union - 2 -4 weeks based on seniority. This is not just a special deal for executives, although they participate also. 

I think this is a fairly common design, and I've seen little in the way of IRS guidance. Thoughts? 

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I recall that bona fide vacation and sick leave plans are not considered deferred compensation, but would suggest the employer have  qualified counsel (legal or industry expert) opine on its particular design/plan.

As another forum contributor disclaims - the free advice you get here (although sometimes very helpful) should be viewed as worth the price you paid.

Kenneth M. Prell, CEBS, ERPA

Vice President, BPAS Actuarial & Pension Services

kprell@bpas.com

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I had hoped for a more substantive response and not a chiding to seek counsel. I happen to be an attorney, and like most who practice in this area, I am frank to say there are times when the opinion of knowledgeable colleagues - lawyers or not - is helpful. Of course there is a vacation plan exception to 457(f). Everyone knows that. The issue that concerns me with this design is the ability to convert vacation days into cash at any time, rather than a cash-out only after retirement. Employers I've seen do not consider plans with optional cash-out dates to be taxable until cash is paid, even though the right is vested. Do you see the problem - the nasty possibility of 409A application? Couldn't a plan like this be considered a right to deferred pay without a set payment date or short term deferral exception? I'm inclined to tell the employer to make the cash-out right less than 100% of the value of a full vacation day, and was simply curious how others who practice may have handled the issue. 

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There's a very thorough treatment of some of the issues you raise here:

https://www.nixonpeabody.com/en/ideas/articles/2013/09/06/ememleave-and-learn-paid-time-off-challenges

My sense is that most PTO plans probably will be bona fide vacation/sick pay plans under 409A and 457(f), especially under the circumstances you describe, and that avoiding constructive receipt is the main design challenge. There is also a discussion in the same piece about the continued use of haircut provisions in PTO cashouts after 409A. 

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4 hours ago, gc@chimentowebb.com said:

I had hoped for a more substantive response and not a chiding to seek counsel. I happen to be an attorney

gc@chimentowebb.com, there are of course proposed 457(f) regulations that are fairly clear and reasonable on this point, and that can be relied on until withdrawn or changed in the final. Given that it is a "facts and circumstances" determination, there is no bright line certainty, but my guess would be that what you describe is probably not outside the boundaries, assuming the amount of vacation per year is reasonable and designed to actually have employees take vacation, i.e. the employee could reasonably be expected to take it and would be unlikely to use it as a "piggy bank." I would probably be concerned if the frequency of "extra staffing needs" led to a situation where the 25% limit on cashouts was seldom applicable in practice. But again, it's facts and circumstances and I'm sure your brief description leaves out some of those. Here is the language from the proposed regulations on this point:

Factors used in determining whether a plan is a bona fide sick or vacation leave plan include whether the amount of leave provided could reasonably be expected to be used in the normal course by an employee (before the employee ceases to provide services to the eligible employer) absent unusual circumstances, the ability to exchange unused accumulated leave for cash or other benefits (including nontaxable benefits and the use of leave to postpone the date of termination of employment), the applicable restraints (if any) on the ability to accumulate unused leave and carry it forward to subsequent years in circumstances in which the accumulated leave may be exchanged for cash or other benefits, the amount and frequency of any in-service distributions of cash or other benefits offered in exchange for accumulated and unused leave, whether any payment of unused leave is made promptly upon severance from employment (or instead is paid over a period after severance from employment), and whether the program (or a particular feature of the program) is available only to a limited number of employees.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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  • 2 weeks later...
On 6/23/2022 at 7:23 PM, Luke Bailey said:

gc@chimentowebb.com, there are of course proposed 457(f) regulations that are fairly clear and reasonable on this point, and that can be relied on until withdrawn or changed in the final. Given that it is a "facts and circumstances" determination, there is no bright line certainty, but my guess would be that what you describe is probably not outside the boundaries, assuming the amount of vacation per year is reasonable and designed to actually have employees take vacation, i.e. the employee could reasonably be expected to take it and would be unlikely to use it as a "piggy bank." I would probably be concerned if the frequency of "extra staffing needs" led to a situation where the 25% limit on cashouts was seldom applicable in practice. But again, it's facts and circumstances and I'm sure your brief description leaves out some of those. Here is the language from the proposed regulations on this point:

Factors used in determining whether a plan is a bona fide sick or vacation leave plan include whether the amount of leave provided could reasonably be expected to be used in the normal course by an employee (before the employee ceases to provide services to the eligible employer) absent unusual circumstances, the ability to exchange unused accumulated leave for cash or other benefits (including nontaxable benefits and the use of leave to postpone the date of termination of employment), the applicable restraints (if any) on the ability to accumulate unused leave and carry it forward to subsequent years in circumstances in which the accumulated leave may be exchanged for cash or other benefits, the amount and frequency of any in-service distributions of cash or other benefits offered in exchange for accumulated and unused leave, whether any payment of unused leave is made promptly upon severance from employment (or instead is paid over a period after severance from employment), and whether the program (or a particular feature of the program) is available only to a limited number of employees.

Thanks, Luke.  I always appreciate your responses. 

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On 6/23/2022 at 4:55 PM, EBECatty said:

There's a very thorough treatment of some of the issues you raise here:

https://www.nixonpeabody.com/en/ideas/articles/2013/09/06/ememleave-and-learn-paid-time-off-challenges

My sense is that most PTO plans probably will be bona fide vacation/sick pay plans under 409A and 457(f), especially under the circumstances you describe, and that avoiding constructive receipt is the main design challenge. There is also a discussion in the same piece about the continued use of haircut provisions in PTO cashouts after 409A. 

EBECatty, That's a good article, and hits all the bases. I appreciate your response.

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