IRS guidance on sick leave plans
Source: Internal Revenue Service, Office of Federal, State and Local Governments, July 2014
Government entities have established a variety of employer plans that provide a retirement benefit for employees based on credit for accumulated unused sick leave.
For example, §167.4 of the Civil Service Law provides that upon the retirement of a State employee whose salary is paid directly by the State, the actuarial value of the employee’s sick leave at the time of his or her retirement is to be used to pay all or part of the individual’s health insurance premium for the individual and his or her dependents during retirement while §41.j of the Retirement and Social Security Law provides for the inclusion of unused sick leave for members in the employ of the State as an employer in addition to any other service credit to which he or she is entitled at the rate of one day of additional service credit for each day of accumulated unused sick leave credit which he or she has at time of retirement for service, not to exceed one hundred sixty-five days.
Administrators of a plan with such features, or an appointing authority considering adopting a plan of this type for its employees, should be aware of how different features of such plans may affect the tax treatment of these benefits. The IRS Office of Federal, State and Local Governments [OFSLG] advises:
General Rule for Recognizing Income
In general, all compensation is included in wages at the time the Employees receive it, unless a specific exception applies.
One such exception, Internal Revenue Code Section 106, which provides that employer contributions to a health or hospital insurance plan for employees or former employees, their spouses and dependents, are excludable from the income of employees, and exempt from withholding for income tax, social security, and Medicare purposes.
When is income considered received?
Under IRC Section 451, individuals recognize income as soon as they have effective control over it; that is, when the funds are made available to the taxpayer without substantial limitations. This is known as the “constructive receipt” rule. Employer-provided health insurance benefits under Section 106 are excludable because, when paid directly by the employer, the employees are not considered to have constructive receipt of income through this benefit.
Generally, Section 106 of the Code provides that health and medical benefits can be provided tax-free by an employer. However, if there is an option/choice to receive cash or an other benefit, this may result in taxable wages, even if the employee does not elect to receive the cash [emphasis supplied].
If you have a plan or are considering a plan that provides for such a feature, you may want to review the IRS analysis, discussed below, that addresses whether or not such amounts can be excluded from an employee’s or former employee’s wages.
Note: Section 125 (“cafeteria”) plans provide a partial exception to the constructive receipt rules. These plans provide a choice between cash wages and a salary reduction to receive an excludable benefit. If the benefit is selected, the value is not included in wages. A Section 125, or cafeteria plan, cannot provide for deferred compensation. Only those benefits specifically indicated in Section 125 are eligible for tax-free treatment.
Revenue Ruling 75-539
Revenue Ruling 75-539 addresses the constructive receipt rules with specific reference to plans involving benefits for accumulated sick leave. This ruling remains the basis for the determining the tax treatment of various plans and has been cited many times since it was issued in 1975.
The ruling analyzes and distinguishes two labor contracts.
Situation 1: Upon retirement an employee will receive either a cash payment representing a part of unused sick leave, or may elect to apply to the employee’s share of the cost of participation in a health plan until the funds are exhausted.
The ruling concluded that, because in the employee had a choice to receive the benefit in cash, it was constructively received as income, even if the employee chose not to use the cash option. Therefore, the value of the benefit is included in gross income.
Situation 2: Upon retirement, the value of a portion of accumulated unused sick leave is placed in an escrow account to pay the full premiums of continued participation in the health plan until the funds are exhausted. No funds may be received in cash, and any unused part of the escrow amount reverts to the employer. Because these amounts were not made available to the employee directly, they constituted employer contributions to a health plan and are excludable from income under Section 106.
For additional information contact one of the following OFSLG Specialists for New York State: Dave Coulon [(315) 233-7305]; Jean Redman [(607-378-0069] or Granville Shannon [(212) 436 -1492].