PTO conversion versus cash advance in practice
Cash advance
At the min. 9.99% APR with a loan amount of $3,000:
At the end of the 730-day (2-year) period:
- Principal Owed: $3,000 (still outstanding since it's an interest-only loan)
- Total Interest Paid: $599.40
In summary, the borrower will still owe the $3,000 principal at the end of the two years, having only paid $599.40 in interest over that time. Additionally, if the employee leaves the company, they will be taxed the federal supplemental tax rate.
PTO conversion
To cash out $3,000 of PTO:
- Employee receives: $2775 ($3,000 minus the 7.5% forfeiture)
- IRS taxes Owed: $610.50 (22% on the $2,775 received)
- IRS required forfeiture (constructive receipt): $225.00 (not out of pocket to the employee)
- Total compensation received: $3000 - $225 (IRS required forfeiture) - $610.50 (Income tax) = $2164.50
Differences between a PTO conversion program and a cash advance
A PTO conversion plan provides a far more beneficial and financially secure option for employees compared to using an on-demand cash advance.
Here’s a comparison of how a PTO conversion plan can help employees avoid the pitfalls of cash advance:
Lower or No Cost vs. High Interest Rates
PTO Conversion Plan: Employees can convert unused paid time off (PTO) into cash or contributions to retirement accounts without incurring interest or fees. It’s essentially a benefit that allows employees to access additional funds they’ve already earned.
Cash Advance: Cash advance loans often come with extremely high interest rates (sometimes 300% or more annually), making them costly short-term solutions. Employees might end up paying far more than they borrow in fees and interest, often creating a cycle of debt.
No Debt Incurred
PTO Conversion Plan: When converting PTO, employees access funds they’ve already accumulated without going into debt. It’s their own money, similar to cashing out a benefit, which avoids the stress of having to repay a loan.
Cash Advance: Cash advance loans must be repaid, typically within a short period (e.g., 2 weeks). Failing to repay on time can result in additional fees and penalties, which may spiral into significant debt.
No Credit Impact
PTO Conversion Plan: There is no impact on an employee’s credit score. PTO conversions are a benefit of employment, and accessing these funds is free of the credit checks or reporting that comes with borrowing money.
Cash Advance: Borrowing through cash advance loans can hurt an employee’s credit score if they miss payments or default. Repeated borrowing or being unable to repay can negatively affect future borrowing potential and financial stability.
Long-Term Financial Security
PTO Conversion Plan: In addition to cash, many PTO conversion plans allow employees to contribute the value of their PTO into retirement accounts (like a 401(k) or Roth 401(k)). This encourages long-term financial wellness by growing retirement savings tax-efficiently, offering a long-term benefit.
Cash Advance: Cash advance loans are strictly short-term financial fixes, often with long-term consequences. Instead of helping employees build financial security, they can exacerbate financial strain and erode savings.
No Stress of Repayment
PTO Conversion Plan: Employees can access their PTO funds with no pressure of having to repay them. It’s a straightforward transaction where they convert unused benefits into immediate financial assistance.
Cash Advance: Cash advance loans come with the burden of repayment, often within a short timeframe. If an employee is unable to repay the loan in full, they may have to take out another loan or pay additional fees, leading to a cycle of debt.
Encourages Healthier Financial Habits
PTO Conversion Plan: Employees are encouraged to manage their PTO responsibly and make informed financial decisions. By offering the option to convert PTO into cash or retirement savings, employers provide employees with a way to boost their financial well-being.
Cash Advance: Cash advance loans can encourage poor financial habits by offering a quick fix to cash flow problems without addressing the underlying issues. They often lead to a cycle of dependency that harms long-term financial health.
Greater Flexibility for Emergency Funds
PTO Conversion Plan: Employees can use PTO conversion as an emergency fund when unexpected expenses arise. By having this option, employees can rely on a safe source of funds rather than taking on risky debt.
Cash Advance: Cash advance loans are often marketed as solutions for emergencies, but the high cost of borrowing can make financial emergencies worse in the long run, leaving employees in worse financial shape.
How does constructive receipt apply?
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.
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.
There are three main ways companies can apply constructive receipt in their organizations:
- 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.
- 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.
- 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.
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 PTO conversion 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.
By offering a PTO conversion plan, employers provide employees with a financially secure alternative to on-demand cash advance, helping them avoid debt traps while encouraging better long-term financial habits.
