Deferring Accumulated Sick and Vacation Pay

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Deferring Accumulated Sick and Vacation Pay

Pat Regetz and Mary Rogers

Internal Revenue ServiceFederal, State & Local Governments

August 13 2013

Pat e-mail: [email protected] e-mail: [email protected]

Direct invitation e-mail: [email protected]

mailto:[email protected]



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ObjectivesDue to time constraints this forum will be limited todeferring accumulated sick and vacation pay to403(b) and 457(b) plans. • At the end of the this forum you will be able

to:– determine when the payments of accumulated sick

and vacation days are subject to Federal Employment Taxes

– determine when taxation of payments can be deferred to a later year

– define an employee elective contribution– define a non-elective employer contribution

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Definitions

IRC 403(b) Plans/Arrangements

• Are retirement plans• Contributions are eligible for tax-deferred

treatment• Available to public schools or exempt 501(c)(3)

organizations, • Purchases annuity contracts or contribute to

custodial accounts • 403(b) plans follow the requirements of Internal

Revenue Code section 403(b). • Also known as “tax-sheltered annuities” or “annuity

contracts”• Refer to plans as “403(b) plans”.

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Definitions

IRC 457(b) Deferred Compensation Plans • Are retirement plans.

• Deferred compensation program for state and local government employees.

• Taxes deferred on amount contributed to retirement savings.

• 457(b) plans follow requirements of Internal Revenue Code section 457(b).

• Refer to plans as “457(b) plans”.

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Definitions

Constructive Receipt

• Principle when income is recognized.

• When the funds are made available without substantial:

– risk, – limitations, or,– forfeiture.

• The constructive receipt rules are found in Internal Revenue Code section 451.

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Definitions Elective Employee Contributions or

Deferrals • Amounts the employee elects to

contribute

• Contributions reduce employee’s salary

• Subject to FICA and Medicare taxes, when applicable to entity

• Deferred for Federal income taxes.

• 403(b) and 457(b) plans accept elective employee contributions or deferrals

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Definitions

Non-Elective Employer Contributions • Contributions the employer chooses to make• Contributions do not reduce the employee’s salary• Non-elective employer contributions must remain

substantially forfeitable until contributed.• Caution - contracts are written intending to provide for

non-elective employer contributions• Additional language stating…”in the event of the

employee’s death, all monies, not yet contributed, will be paid to the estate”.

• Statement indicates the money is substantially non-forfeitable

• Qualified non-elective employer contributions must remain forfeitable

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Definitions Post Employment Employer

Contributions • Only 403(b) can allow post employment

employer contributions. • Plan must allow for post employment

employer contributions• Subject to annual limits• Maximum 5 years after end of

employment• Amounts not deposited must remain

substantially forfeitable

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Definitions

Substantially Forfeitable

• Benefits belong primarily to the employer

• Can be rescinded by the employer.

• At death or other event, remaining funds not deposited revert back to employer.

• Funds not deposited cannot be paid to employee’s estate.

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Definitions

Substantially Non-Forfeitable

• Benefits belong primarily to employee

• Cannot be rescinded.

• At death, monies will be paid to the employee’s estate.

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Definitions Taxability – 403(b) Plans

• Employee elective contributions are subject to FICA and Medicare taxes, when the payments are made, if the employer is subject to these taxes.

• Non-elective employer contributions are exempt for FICA and Medicare taxes and Federal income tax is deferred until withdrawn.

• Post-employment employer contributions are exempt for FICA and Medicare taxes and Federal income tax is deferred until withdrawn.

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Definitions Taxability – 457(b) Plans

• Employee elective contributions are subject to FICA and Medicare taxes, when the payments are made, if the employer is subject to these taxes.

• Non-elective employer contributions are exempt for FICA and Medicare taxes and Federal income tax is deferred until withdrawn.

• Post-employment employer contributions are not allowed.

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Situation 1Cash payout – no options

Facts

• Collective Bargaining contract provides for cash payout of accumulated sick and vacation pay.

• Payment will be made in a lump sum 30 days following the date of retirement.

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Situation 1Cash payout – no options

Law

Fully taxable on the earlier of date paid outor 30 days after retirement.• Examples:a) Employee retires June 30 2013

Taxation would be July 30 2013, or date actually paid, if earlier.

b) Employee retires December 31 2013 Taxation would be January 30 2014, or date

actually paid, if earlier.

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Situation 2 Cash Payout – With Payment Options

Facts• Collective Bargaining contract provides for cash

payout of accumulated sick and vacation days as of the date of retirement.

• Employee has the option to:– Take a lump sum payment which will be paid within

30 days following the date of retirement, or,– Defer payment until the first pay day in the following

calendar year, or,– Take the payment in three equal installments over a

three year period commencing within 30 days after the date of retirement. Subsequent payments will be on the anniversary date of the first payment.

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LawOption A: Take a lump sum payment which will bepaid within 30 days following the date of retirement.• Fully taxable on the earlier of date actually paid or 30 days

following the date of retirement.• Examples:1. Employee retires December 15, 2012 and payment was made

December 30, 2012.– Taxation would be December 30, 2012 the date actually paid,

which is earlier than 30 days after

2. Employee retires June 30, 2013 and payment was made August

5, 2013 – Taxation would be July 30, 2013, which is the earlier of the

date paid which is August 5, 2013, or 30 days after retirement which is July 30, 2013.

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Law

Option B: Defer payment until the first payday in the following calendar year.• Deferral is chosen by the employee. • Employee cannot be given the option to defer • taxation to another tax year. • Constructive receipt has already occurred in

the earlier year. • Fully taxable on earlier of the date actually

paid or 30 days following the date of retirement.

• Refer to payouts - Situation 1 (Slide #14)

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Law

Option C: Take the payment in three equal installmentsover a three year period commencing within 30 days afterthe date of retirement. Subsequent payments will be onthe anniversary date of the first payment.• Fully taxable on earlier of the date actually paid or 30

days following the date of retirement. • Refer to the Options A and B above. • Again, an employee cannot be given the option to

defer taxation of the money to another year or years.

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Situation 3The Police Chief and the 457(b) Plan

Facts

• Police Chief has an employment contract with the City.

• Employee is entitled to all accumulated sick and vacation days, as of the date of retirement.

• Employee may designate a portion of the monies as an elective employee contribution to 457(b) plan for the year of retirement (to the maximum allowed by law – 2013 $17,500)

• Remaining monies will be paid within 30 days of the date of retirement.

• Neither employment contract or the plan document allow for non-elective employer contributions.

• In the event of the employee’s death, all monies will be paid to the employee’s estate.

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Situation 3The Police Chief and the 457(b) Plan

Law• Straight forward employment contract

• Value of the accumulated sick and vacation days are wages and the employee can make an employee elective contribution

• For 2013, the maximum allowed is $17,500 • If the police chief had already contributed $10,000 to his account

through his regular wage withholding then he would be entitled to contribute the remaining $7,500 from his accumulated sick and vacation pay.

• Amount that represents an elective employee contribution is subject to FICA and Medicare, if the employer is liable

• Federal Income tax is deferred until the money is withdrawn.

• The balance of the accumulated sick and vacation pay must be paid in a lump sum within 30 days of the date of retirement

• Subject for Federal Income tax, and FICA and Medicare taxes apply, if the employer is liable.

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Situation 3Amending the Contract

Facts

• Retirement papers effective June 30, 2013. • Value of the accumulated sick and vacation days is

$100,000. • Approximate Federal Income tax on the due to

$100,000 accumulated sick and vacation plus $150,000 in excess of $60,000

• Chief approaches the City about the tax impact. • May 1 2013, City and Chief execute an amendment to

the original employment contract.

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Situation 3Amending a Contract

Facts (con’t)The amended employment contract provides:• Payout of the accumulated sick and vacation pay will

be as follows:– A non-elective employer contribution $17,500 will be made to

the City’s 457(b) year of retirement and each of the three subsequent years following retirement.

– Elective employee contribution of $17,500 (or the maximum allowed by law) to the City’s 457(b) plan for the year of retirement.

– The remaining monies distributed in a lump sum within 30 days of the date of retirement.

– In the event of the employee’s death, before all monies are distributed, the remaining monies will be paid to the employee’s estate.

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Law

• The amended employment contract was clearly executed to avoid paying Federal Employment Taxes.

• Would invalidate the contract.

• Amended employment contract is not considered an arm’s length transaction and would not be valid.

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Law

• Plan document does NOT accept non-elective employer contributions

• 457(b) plans cannot accept post employment employer contributions.

• Current year non-elective employer contribution would not be acceptable.

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Law

• The elective employee contribution and the cash • payout 30 days after retirement are fine. • The entire amount would be subject to

FICA/Medicare, if applicable.• The lump sum payment would be taxed the earlier

of the date paid or 30 days after the date of retirement.

• The amount contributed would be subject to Federal income Tax when withdrawn.

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Law

• Language…”in the event of the employee’s death”…” remaining monies will be paid to the employee’s estate”.…

• Does not apply in this situation as plan does not accept non-elective employer contributions and post employment contributions not allowed

• Payment to the estate makes the fund non-forfeitable

• Non-elective employer contribution must remain with employer until contributed

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Situation 4403(b) Plans – Post Employment

Employer Contributions

Facts: • A school superintendent has an employment

contract which provides the following:– As of the date of retirement, all the sick and vacation

time accumulated by the superintendent will be paid in five equal annual installments (to the maximum allowed by law) to the employee’s 403(b) plan in the form of a non-elective employer contribution.

– In the event of the employee’s death prior to retirement or prior to all monies being deposited in the employee’s 403(b) arrangement, all remaining monies will be paid to the employee’s estate.

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Situation 4403(b) Plans – Post Employment

Employer ContributionsLaw

• Taxable as of the date of retirement. • This arrangement actually started out

sounding fine but the clause for payable at death changed the funds from forfeitable to non-forfeitable.

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Situation 5 Maximum Cash Payout

plus Employer ContributionFacts

The employment contract for the Chief Finance Officerstates the following:• At retirement, the employee will be paid for

accumulated sick and vacation days to the maximum amount of $15,000.

• Payment will be in a lump sum distribution payable in full on the date of retirement.

• Any additional accumulated sick and vacation days in excess of $15,000 will be contributed to the City’s 457(b) plan as a non-elective employer contribution.

• The non-elective employer contribution will not exceed $15,000.

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Situation 5 Maximum Cash Payout

plus Employer ContributionLaw

• The $15,000 lump sum is taxable wages as of the date of retirement.

• The lump sum is subject to Federal income tax, FICA, and Medicare taxes, where applicable.

• The non-elective employer contribution is a qualified non-elective employer contribution and not currently subject to Federal Income, FICA, or Medicare taxes.

• The non-elective employer contribution will be subject to Federal income taxes when withdrawn.

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Situation 6 Employer Mandates Payment

Over Multiple YearsFacts

• Collective Bargaining contract provides for cash payout of accumulated sick and vacations.

• Per the contract, due to budget considerations, the employer will pay the accumulated sick and vacation in three equal annual installments beginning with the year of retirement.

• Subsequent installments will be paid on the anniversary of the date of retirement.

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Situation 6 Employer Mandates Payment

Over Multiple YearsLaw

• Taxable in each of the three years of payment as paid.

• This is 100% acceptable. • EMPLOYER can defer the payment to another year

as long as it was negotiated in an arms length • transaction. • Employee can NEVER be given the current option

to defer the payment

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Summary

• Does the worker have a right to receive the cash?

• The worker does not have to exercise that right.

• The • Simple existence of the right to receive the cash

is sufficient for taxation. • This right is present when a worker is given an

option of when to receive the funds.

Documents

Deferring Accumulated Sick and Vacation Pay