Whether your employees want more vacation or more cash, a paid time off (“PTO”) purchase plan is an attractive benefit that allows employees the flexibility to receive what is most important to them. More companies are offering employees the option to buy and sell vacation days in exchange for compensation. These PTO purchase plans, sometimes referred to as “PTO buy-sell programs” can be designed in a number of ways to suit each employer’s and employee’s specific needs. These plans can be implemented as standalone programs, but certain tax advantages attach if they are offered through a company’s cafeteria plan. As a result, most PTO purchase plans are offered through a cafeteria plan.
When the PTO purchase plan is offered through a cafeteria plan, PTO can be bought and sold on a pre-tax basis. The cafeteria plan can permit employees to elect to receive either more or less PTO than the employer otherwise provides to employees on a nonelective basis. A cafeteria plan, also known as a “Code Section 125 plan” or “flex plan,” is a plan established by an employer in order to facilitate pre-tax payment for certain benefits. Cafeteria plans allow employees to pay for benefits, such as health insurance and dependent care, with pre-tax dollars.
Cafeteria plans must offer a choice between a taxable benefit, such as cash, and one qualified benefit, such as group health insurance. PTO can be bought and sold on a pre-tax basis through a cafeteria plan. If an employer offers the PTO purchase plan through a cafeteria plan in order to receive the tax advantages, the cafeteria plan cannot offer only either cash or PTO. As mentioned above, qualified benefits must also be offered. Therefore, an employer must have a cafeteria plan in place facilitating pre-tax qualified benefits such as group medical care, health flexible spending accounts, or dependent care flexible spending accounts.
Employers have lots of flexibility in choosing how to design the plan. Establishing detailed election forms and notices to ensure the participating employees understand their options and rights under the PTO purchase plan allow employers to effectively communicate the plan design to employees. The following aspects of a PTO purchase plan can be implemented however the employer sees fit:
• Eligibility. Employers are free to set eligibility requirements for participation in the PTO purchase plan. Additionally, employers must choose which types of PTO are eligible for purchase or sale under the plan.
• Buying, Selling, or Both. Employers must decide whether they want employees to be able to purchase PTO, sell PTO, or both. While most employers only offer a purchase option in order to keep the plan simple, other employers make the plan more complex. In fact, some employers choose to allow employees to use flex credits to purchase PTO rather than salary reduction. For example, if an employer’s cafeteria plan uses flex credits, an employer could allow an employee to use flex credits to purchase PTO or to sell PTO in exchange for more flex credits. Other employers allow employees to sell PTO days in exchange for nontaxable benefits under the cafeteria plan, such as major medical care or dependent care benefits.
• Number of PTO Days Available. Each employer can choose how many days an employee is able to purchase or sell. For example, an employer could allow employees to purchase up to 5 days of PTO in 8 hour increments through pre-tax salary reductions.
• Forfeiture or Cash-Out. Employers may choose whether employees will automatically forfeit unused PTO at the end of the year, or whether employees will be automatically cashed out for unused PTO. As explained below, unused elective PTO cannot be carried over into subsequent plan years. Therefore, employers must choose between cashing employees out (returning the purchase price to employees) at the end of the year or forcing employees to forfeit unused PTO. However, employers must be wary of state laws imposing restrictions on the forfeiture of unused PTO.
• Terminations, Leaves of Absence, and Changes in Status. Employers must also consider how to approach terminations, leaves of absence, and changes in benefit status. For example, if an employee terminates employment with unused PTO he had purchased through the plan, he would be entitled to a refund upon termination. Alternatively, if a termination occurs after an employee has taken too many PTO days, he would owe the company money upon termination. The same issues arise when an employee has a change in status making him ineligible for benefits or when an employee takes an unpaid leave of absence.
• Valuing Unused PTO. The employer has the responsibility for valuing unused PTO. In other words, the employer must decide what the cash-out value of one day of PTO will be. The PTO could be valued at the original purchase/sale rate, or it could be valued based on the employee’s compensation when the cash out occurs. The value of the PTO could also be discounted. For example, when employees choose to receive additional compensation in exchange for PTO, it is often paid to employees in increments through their paychecks throughout the year. Some employers reimburse sold PTO days on a dollar-for-dollar basis, while others apply a discount (e.g., 75 cents on the dollar).
Although the IRS allows employers lots of room to tailor the PTO purchase plan in a way that best suits the company’s needs, as well as the needs of its employees, there are certain rules that must be followed. The Internal Revenue Code (the “Code”) lays out strict rules each PTO purchase plan must comply with in order to offer a PTO purchase plan. The following rules apply to PTO purchase plans through the cafeteria plan regulations:
• Exhaust All Company PTO. One rule applicable to PTO purchase plans is that all PTO offered under the company’s PTO policy must be exhausted before using any PTO purchased under the plan. In other words, an employee must use all “nonelective” PTO available to them prior to using any “elective” PTO bought through the cafeteria plan. A PTO purchase plan must be drafted in accordance with the company’s PTO policy. This rule could make implementation of a PTO purchase plan difficult when the company policy allows employees to carry forward nonelective PTO.
• No Carryovers. Unused PTO must be either cashed-out or forfeited as of the last day of the plan year for all participating employees. In other words, elective PTO cannot be carried forward into future years if the employee fails to use it. As described above, the employer gets to choose whether it will provide employees with a cash-out or require them to forfeit the unused amounts (if allowed by law). The employer also determines the value of the unused PTO.
• No Grace Period. Cafeteria plans allow for certain grace periods applicable to benefits offered under the plan. However, the Code specifically prohibits a PTO purchase plan from allowing any grace periods under the plan.
• Cash Outs are Taxable Income. Cash outs at the end of each plan year must be included in the employees’ taxable income. This feature encourages employees to use their unused PTO prior to the end of the year.
There are two other challenges associated with the implementation of a PTO purchase plan: (1) the applicability of state law; and (2) the administrative burden. Many states regulate the use of accrued vacation time and salary reductions. Each PTO purchase plan must be drafted in accordance with the relevant state laws. This can pose a challenge for employers with employees in multiple states; therefore, legal counsel is recommended in order to ensure state law compliance. Additionally, employers face an administrative burden upon the implementation of a PTO purchase plan. Participating employees all have unique deductions or payments based on salary and on the PTO purchased and sold under the plan.
Despite these challenges, PTO purchase plans are increasingly popular among many employers as employees begin to demand more time off for family and travel. In a changing environment for companies and their benefit offerings, PTO purchase plans can serve as a great tool for incentivizing employees to stay at the company or for influencing target hires to join the company. PTO purchase plans provide employees with flexibility depending on their individual lifestyles.
If you are interested in establishing a PTO purchase plan at your company or would like to learn more about the implementation process, please contact one of McGrath North’s employee benefits attorneys.