How to deal with the biggest IRS issue employers didn’t know they had

25 Jun

How to deal with the biggest IRS issue employers didn’t know they had

It’s a common benefit to offer, and one that can add up quickly. It’s an employer paying out accumulated unused sick, vacation or any other form of financial incentive to their employees at retirement.

The figures add up. In New York, an attorney in the city’s law department received a $211,779 payout after stockpiling 120 days of sick leave and 135 vacation days. In Massachusetts, the president of a community college received a one-time $266,060 payment for 1,250 unused sick days earned over his 46-year career. In aggregate, $272 billion in accumulated vacation time is sitting on the balance sheets of U.S. businesses this year, according to a new Project: Time Off report — a liability that has surged 21% in just the last year.

On the surface, your employees might be thrilled at the payout, given that the average household between 55 and 61-years-old only has $163,577 saved for retirement. In fact, awaiting the benefit may well have helped to retain those team members as part of a loyal, hardworking workforce.

However, this specific form of disbursement — which can range from cash to transfers into medical or retirement accounts — may fail to meet their actual needs at retirement, particularly if they find themselves facing steep healthcare costs. Further, depending on how the money is disbursed, taxes could eat away a substantial portion of the payout.

Meanwhile, the employer faces its own share of risks and costs. It must figure out how to pay an unfunded liability and it could well owe significant taxes on its accumulated payouts of retiring workers. One large city with nearly 250,000 residents found itself paying hundreds of thousands of dollars annually in Medicare and Social Security taxes on its accumulated leave payout after which its tax bill on this benefit dropped to $0.

Worse, these payouts can put the employer at risk of an obscure and often overlooked tax issue known as constructive receipt which can cause massive and costly tax problems for organizations. The problem: the IRS treats benefits as taxable income in some situations even if the employee doesn’t receive the benefit as cash. The IRS has determined that “income is constructively received when an amount is credited to your account or made available to you without restriction. You do not need to have possession of it.” This means that any time employees can choose how they want to receive their accumulated leave pay, and one of those choices is cash, it makes all options at that point taxable income.

A plan of action

How can employers capitalize on the business opportunities afforded by a competitive and highly differentiated benefit without facing heightened tax risk and other problems? And perhaps more importantly, how can an entity solve this potentially costly issue?

First, set up a single program with two tax-advantaged options: A tax-free, employer sponsored health reimbursement account that allows participants to use the payout to pay for health insurance and other qualified medical expenses, or set up a tax deferred IRC Sec 401(a) or 403(b) plan, if the employee doesn’t need the money for healthcare.

Second, select the right option for each individual employee. An exit interview conducted on behalf of the employer removes employee choice while ensuring the right choice is made. For example, Susan retires and qualifies for a $15,000 payout, but she is also facing a $750 per month health premium for herself and her husband. The employer could divert the money to a medial trust which would pay for years’ worth of health premiums. No FICA, federal or other state taxes will be assessed on the amount, thus Susan can reap the benefits of the full amount. On the other hand, if Susan doesn’t need the money for healthcare, a 401(a) or a 403(b) account option gives her tax deferred access to the money, in an account with complete liquidity.

Lastly, the retiree receives an enhanced payout as taxes can be eliminated or deferred, and the benefit can help them cover post-retirement expenses using tax-advantaged vehicles.
Employers reap a more than substantial cost savings as well as a more strategically structured program that can help reduce the pain associated with unfunded liabilities.

A program plan that can deftly navigate the applicable tax rules can enable your organization to realize advantageous business outcomes of this benefit, even as you save more money and stave off tax risks in doing so.