Paid-Time-Off Tax Trips for Unwary Employers

One of many perks employers offer employees, is the right to take earned paid time off (i.e. vacation, sick, personal days) in cash, instead of taking the actual days off.  Like many good things, no good deed goes unpunished: this gracious perk can result in unintended tax consequences for both the employee and the employer.
The IRS has stated that if an employee has the right to cash payment for unused paid time off, then he is taxed on the value of the PTO in the year when that right becomes permanent, even if he doesn’t receive payment.  The employee now has to pay tax on vacation time, even if he hasn’t received cash yet.  And, as the employer, you have to pay the payroll taxes on it.  Of course, the employer didn’t know any of this so he never withheld income taxes on the earned PTO, and he never paid additional payroll taxes to the IRS.  As you can imagine, the IRS doesn’t like when this happens so they assess penalty and interest against the employer.

Even more worrisome, the IRS can assess these unpaid payroll taxes again the business owner personally.

But wait, it gets better.  When those unused vacation days are paid out the following year, the employer better make sure it’s not included on the employee’s W-2 (otherwise, the employee is taxed twice).

Now that you have this information, make sure your tax reporting is consistent with your paid time off policies.  More importantly, make sure your payroll procedures and those of your payroll provider (i.e., ADP, Paychex) are consistent with how you are reporting and paying paid PTO.

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