How Constructive Receipt Applies to Convertible PTO


Constructive receipt is a fundamental taxation principle crucial in determining when income is considered realized and taxable. This doctrine, rooted in the Internal Revenue Code (IRC) of the United States, aims to prevent taxpayers from manipulating the timing of income recognition to gain tax advantages.   

Constructive receipt focuses on control over income, emphasizing that taxpayers are liable for taxes when they have control or the right to income, even if they have not yet received it. It is yet to be when a cash-basis taxpayer has received gross income. A taxpayer is subject to tax in the current year if they have unfettered control in determining when items of income will or should be paid.  

How constructive receipt works  

Constructive receipt occurs when income is made available to a taxpayer, regardless of whether they physically received it. According to the doctrine, income is considered constructively received when it is credited to the taxpayer's account, set apart for them, or made available so they can draw upon it at any time. This principle ensures that taxpayers cannot defer recognizing income simply by choosing not to physically receive it.   

The doctrine highlights three main components:   

  • Availability of funds: Constructive receipt hinges on the availability of funds to the taxpayer. If income is earmarked for an individual and they can access or direct the funds, it's treated as constructively received.  
  • No substantial limitations: The doctrine requires that no significant limitations or restrictions prevent taxpayers from accessing the income. Any control or restriction significantly hampers the taxpayer's ability to use the funds and may delay income recognition.  
  • Understanding control: Control is a central concept in constructive receipt. If a taxpayer can control the disposition of income, even if it remains unclaimed or uncollected, it is considered constructively received.

How companies can apply constructive receipt   

There are three main ways companies can apply constructive receipt in their organizations: 

  1. Deferred compensation: The doctrine often comes into play in the context of deferred compensation plans. If an employee can receive deferred income at any time, it is constructively received when it becomes available, regardless of when the employee chooses to take possession.
  2. Gifts and bequests: In cases involving gifts or bequests, a constructive receipt may apply if the recipient has the immediate right to the income, even if they choose not to accept it immediately. This prevents taxpayers from delaying income recognition by deferring the acceptance of a gift or bequest. 
  3. Business transactions: Constructive receipt is relevant in various business transactions, especially when funds are set aside for a party. The timing of income recognition can impact tax liability and financial reporting.   

How constructive receipt applies to convertible PTO  

Accrued vacation or PTO is considered deferred compensation, subject to the constructive receipt doctrine. Because of this, the IRS does not allow employees to receive the total value of their accrued PTO when they exchange it.    

To maintain compliant, an employee must accept a forfeiture or implement a service charge on the value of the time they make an exchange. The service charge added to every exchange an employee makes in our platform addresses the substantial restriction or limitation requirement that allows access to accrued time without invoking constructive receipt. Service charges typically range from 7.5% to 20%, depending on how the company wants to structure the program.  

For example, a typical transaction looks like:   

For an employee who makes $25/hour and exchanges 8 hours for a 401(k) contribution, the exchange would look like this:  

8 hours * $25/hour = $200  

$200 minus the 7.5% service charge = $185  

The employee would see a $185 earning and corresponding deduction on their next paycheck. $185 will flow into their 401(k) account, and 8 hours will be deducted from their PTO balance.  

If the exchange were a PTO cash out, the exchange would look like this:  

8 hours * $25/hour - $200  

$200 minus the 7.5% service charge = $185  

The employee would see an additional $185 in gross wages on their next paycheck. It would be treated like regular W-2 wages and taxed appropriately, and the net amount would fall into their earnings.  

Compliant companies are happy companies   

Constructive receipt is a vital tool in the tax landscape, preventing taxpayers from manipulating income recognition for tax advantages. By focusing on the availability and control of income, this doctrine ensures a fair and consistent approach to determining when income is deemed received, contributing to the tax system's integrity. Understanding constructive receipt is essential for individuals, businesses, and tax professionals to navigate the complexities of income recognition and fulfill their tax obligations lawfully.  

Request a demo of PTO Exchange today to learn how to implement a convertible PTO program at your organization.

Published on Feb 01, 2024 by Rob Whalen

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