Feb 29, 2024
Purchase or Sale of Paid Time Off (PTO) Through a §125 Cafeteria Plan
February 2024
Background
§125 Cafeteria plans are generally set up to give employees access to a range of tax-free benefits such as health insurance, flexible spending accounts, life insurance up to $50,000, etc. The option to purchase additional vacation, sick leave, or paid time off (PTO) (jointly referred to as “PTO days” for the rest of this summary) is a taxable benefit some employers also include in their cafeteria plan.
PTO that can be bought or sold under a cafeteria plan is referred to as “elective” PTO days. Regular PTO accruals outside of the cafeteria plan for which the employee had no election are referred to as “non-elective” PTO days.
The PTO buy/sell plan must not operate in a manner that defers compensation under the cafeteria plan rules. Under these rules, elective PTO days generally:
- must be used,
- cashed out, or
- forfeited by plan year-end.
Note: Elective PTO days cannot be carried over from one plan year to the next. There is also a special "ordering rule" under which non-elective PTO days must be used first.
When PTO buying is offered, an employee who wants more PTO days may purchase additional days for use during the following plan year. When PTO selling is offered, employees can elect to
- sell PTO days that would otherwise accrue during the following plan year,
- receive the value of the sold days as additional taxable compensation during the following plan year or
- use it to purchase non-taxable benefits offered under the cafeteria plan (e.g., major medical, health FSA, or DCAP benefits).
When additional taxable compensation is received, it is often paid in increments in employees' paychecks during the year. Some employers reimburse sold PTO days on a dollar-for-dollar basis, while others apply a discount (e.g., 50 cents on the dollar).
Unused Elective Days Must Be Cashed Out or Forfeited
Under the 2007 proposed regulations, a cafeteria plan must provide for the cash-out or forfeiture of any elective PTO days that are unused as of the last day of the plan year. This provision must apply uniformly to all participants in the cafeteria plan.
- Cash-outs must be received by participants on or before the last day of the plan year and should be treated as taxable income.
- Forfeitures must be effective as of the last day of the plan year.
While a cash-out feature is used under many plans, some employers may prefer to provide for a forfeiture to encourage employees to take PTO or to avoid year-end payments. Alternatively, requiring forfeiture may result in scheduling hardships (especially in a cyclical business) and may be contrary to state laws regarding vacation time.
Non-Elective Days Must Be Used First
The proposed cafeteria plan regulations establish an "ordering rule" that applies when PTO buying or selling is offered under a cafeteria plan. Under this rule, non-elective PTO days (i.e., regular PTO accruals outside of the cafeteria plan for which the employee had no election) must be used before elective PTO days. To put it another way, elective PTO days are used only after all non-elective PTO is used by the employee. The practical consequence of this rule is that employees must use all of their PTO (elective and non-elective days) in order to avoid a cash-out or forfeiture of any elective days. Thus, a PTO buy/sell feature under a cafeteria plan may not fit well with a PTO plan that allows unused non-elective PTO days to carry over to future years.
Pros and Cons of Offering PTO Buying and Selling
Offering PTO buying or selling under a cafeteria plan can provide flexibility to employees. Employees who want more time off can purchase additional days, while employees who prefer additional cash (or, depending on the plan design, non-taxable benefits under the cafeteria plan) can sell PTO days. Additionally, plans with a cash-out feature allow employees to receive money back for unused elective PTO days at year-end, a concept that is otherwise unheard of in the cafeteria plan world.
On the other hand, some employers find the ordering rule limiting. Although a cash-out feature mitigates the rule's effect, some employees would rather be able to carry over all of their unused PTO. And the ordering rule is especially limiting for employees when the plan does not provide for a cash-out at year-end. Consequently, employers considering the addition of a PTO buy/sell feature under their cafeteria plans must keep in mind the ordering and cash-out/forfeiture rules that apply under the regulations.
While every effort has been taken in compiling this information to ensure that its contents are totally accurate, neither the publisher nor the author can accept liability for any inaccuracies or changed circumstances of any information herein or for the consequences of any reliance placed upon it. This publication is distributed on the understanding that the publisher is not engaged in rendering legal, accounting, or other professional advice or services. Readers should always seek professional advice before entering into any commitments.
