Deferring Accumulated Sick and
Vacation Pay
Pat Regetz and Mary Rogers
Internal Revenue Service
Federal, State & Local Governments
August 13 2013
Pat e-mail: Patricia.A.Regetz@irs.gov
Mary e-mail: Mary.E.Rogers@irs.gov
Direct invitation e-mail: tege.fsl.7251@irs.gov
1
Objectives
Due to time constraints this forum will be limited to
deferring accumulated sick and vacation pay to
403(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
2
Definitions
IRC 403(b) Plans/Arrangements
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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”.
3
Definitions
IRC 457(b) Deferred Compensation Plans
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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”.
4
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.
5
Definitions
Elective Employee Contributions or
Deferrals
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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
6
Definitions
Non-Elective Employer Contributions
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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 nonforfeitable
Qualified non-elective employer contributions must
remain forfeitable
7
Definitions
Post Employment Employer
Contributions
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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
8
Definitions
Substantially Forfeitable
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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
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Benefits belong primarily to employee
Cannot be rescinded.
At death, monies will be paid to the
employee’s estate.
10
Definitions
Taxability – 403(b) Plans
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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.
11
Definitions
Taxability – 457(b) Plans
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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 1
Cash payout – no options
Facts
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•
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 1
Cash payout – no options
Law
Fully taxable on the earlier of date paid out
or 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.
14
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.
15
Situation 2
Cash Payout – With Payment Options
Law
Option A: Take a lump sum payment which will be
paid 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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Situation 2
Cash Payout – With Payment Options
Law
Option B: Defer payment until the first pay
day in the following calendar year.
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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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Situation 2
Cash Payout – With Payment Options
Law
Option C: 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.
•
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 3
The Police Chief and the 457(b) Plan
Facts
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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 3
The Police Chief and the 457(b) Plan
Law
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Straight forward employment contract
Value of the accumulated sick and vacation days are wages and the
employee can make an employee elective contribution
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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.
•
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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 3
Amending the Contract
Facts
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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 3
Amending a Contract
Facts (con’t)
The amended employment contract provides:
•
Payout of the accumulated sick and vacation pay will
be as follows:
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–
–
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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.
22
Situation 3
Amending a Contract
Law
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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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Situation 3
Amending a Contract
Law
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Plan document does NOT accept nonelective 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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Situation 3
Amending a Contract
Law
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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.
25
Situation 3
Amending a Contract
Law
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•
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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 nonforfeitable
Non-elective employer contribution must
remain with employer until contributed
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Situation 4
403(b) Plans – Post Employment
Employer Contributions
Facts:
•
A school superintendent has an employment
contract which provides the following:
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–
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.
27
Situation 4
403(b) Plans – Post Employment
Employer Contributions
Law
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•
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.
28
Situation 5
Maximum Cash Payout
plus Employer Contribution
Facts
The employment contract for the Chief Finance Officer
states 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 Contribution
Law
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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.
30
Situation 6
Employer Mandates Payment
Over Multiple Years
Facts
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•
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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.
31
Situation 6
Employer Mandates Payment
Over Multiple Years
Law
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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.
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