What is constructive receipt?
For public agencies, constructive receipt generally relates to an agency’s process for cashing out leave accruals. Does your agency allow leave cashouts for vacation, sick, personal, or floating holiday accruals? If so, constructive receipt is in play with your process on how you have employees request the cashouts.
Under section 1.451-2(a) of the Code of Federal Regulations, income is constructively received—and, as such, taxable—in the taxable year during which it is credited to a taxpayer's account, set apart, or otherwise made available so that the taxpayer may draw on it at any time.
A key aspect of constructive receipt is the taxpayer’s control of the income. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. Without a limitation or restriction on a taxpayer’s ability to take cash payments of accrued leave (in lieu of using the amount for leave time), the Internal Revenue Service (IRS) considers the entire leave amount available for such cashouts as taxable wages—even if the employee doesn’t elect or receive any cashout.
This IRS position is articulated in several private letter rulings and 2014 Federal State and Local Government (FSLG) guidance. Links and summaries of this information can be found at the end of this article.
Fortunately, the private letter rulings also carve a path for avoiding the application of constructive receipt to accrued leave cashout programs. Specifically, the IRS has ruled that leave cashouts aren’t subject to constructive receipt if:
- To receive a cashout, an employee must irrevocably elect the cashout by December 31st of the year BEFORE the cash out payment, and
- the cashout is limited to the amount of leave earned by the employee in the year of the payment.
What’s the risk?
If the IRS audited an agency not in compliance with constructive receipt, current and former employees and/or the agency may be liable for unpaid state and federal income taxes, Social Security taxes, and Medicare taxes for the statute of limitations where accrued leave balances should have been reported as gross wages on a W2.
Let’s say an agency is audited and forced to bring payroll practices into compliance with constructive receipt. The agency did not comply with constructive receipt rules regarding 40 hours of vacation leave that should have been reported as wages on a W2. For an agency where the average rate of pay is $40 per hour, the liability could look like this:
$40 per hour x 40 hours of reportable vacation leave = $1,600
Federal Taxes (assume 22%) = $352
State Taxes (assume 10.23%) = $164
Social Security (if applicable, 12.40%) = $198
Medicare (2.90%) = $46
Total tax liability1 = $760
Now, let’s say this applies to 200 employees at the organization. The one-year tax liability is $152,000. Assuming a three-year statute of limitations, the total tax liability is $456,000, plus interest and possible penalties. The agency would be responsible for amending three years of W2’s, putting employees on the hook for repaying past taxes due or deciding to cover the tax liability as an agency. Both scenarios would be difficult to discuss with agency staff, leadership, and governing bodies.
Scenarios of constructive receipt risk and correction
Scenario 1 – Vacation Leave
- Leave type: Vacation
- Leave accrual per year: 80 hours
- Cashout process: Employees may cashout up to 50% (40 hours max) of accrued vacation leave each calendar year. Employees request the amount of vacation leave to be cashed out in December, it is paid in January. For example, in December 2025 the employees will elect their unused vacation leave to be cashed out in January 2026.
- Constructive receipt risk: Although there is a “restriction or limitation” in place and the cashout is limited to the amount of leave earned by the employee in a calendar year, the request for cashouts isn’t confined to accruals earned in the next calendar year, but rather applies to already accrued amounts. This does not follow IRS guidelines.
- Correcting the constructive receipt risk: Adjust the election and payment period. For example, allow the employees to make an irrevocable election in 2024 to cashout hours they will accrue in 2025.
- Tip from an agency that has implemented constructive receipt: Communicate to employees that there is no “use” penalty for making the irrevocable election. If employees make an irrevocable election in 2024 to cashout the max hours that they could accrue in 2025 (40 hours), it doesn’t mean they can’t use all their leave during calendar year 2025 before the scheduled cashout date.
For example, assume that in December 2024, an employee who has 40 hours in her leave bank irrevocably elects to cashout all 40 vacation hours that the employee is scheduled to earn in 2025, and in 2025, the employee uses 70 hours, leaving only 10 hours of vacation leave in her bank when the cashout date arrives. With these facts, the 10 hours would be cashed out.
Now assume the same facts, except that the employee uses only 20 hours of leave in 2025, leaving a balance of 60 hours. Here, her full elected amount of 40 hours would be cashed out, and 20 hours would carry over to the next year.
Scenario 2 – Personal Leave
- Leave type: Personal
- Leave accrual per year: 40 hours
- Cashout process: Employees may cashout personal leave at any time by providing a form to payroll.
- Constructive receipt risk: There is no irrevocable election or other “restriction or limitation” in place. Employees’ cashout requests from their personal leave balance may be a mix of current-year and prior-year accruals (not limited to the amount of leave earned by the employee in the year of payment per IRS guidelines).
- How to correct the constructive receipt risk: Implement an irrevocable election prior to December 31st of the year before the cashout payment. The cashout election would be limited to 40 hours, which is the amount of leave earned by the employee in the year of the payment.
- Tip from an agency that has implemented constructive receipt: If the agency’s employees are used to a process where they can request leave any time, understand the personal financial burden a change in the process may create. To minimize the burden, your agency could allow immediate cashouts of accrued leave for financial emergencies. Such cashout programs don’t trigger constructive receipt because the IRS considers the “emergency” condition for the cashout to be a substantial limitation or restriction.
Conclusion
Note that outside the private letter rulings and FSLG guidance, the IRS has not provided any formal guidance on constructive receipt’s application to leave cashout programs. No policy or procedure is guaranteed to eliminate risk, but patterning policies after the private letter rulings may significantly reduce risk.
Communication is key when an agency pursues changes in leave cashout processes to comply with constructive receipt. IRS guidelines and rulings are difficult to understand, and changing processes involving employee cashouts is a sensitive issue. Materials and presentations to employees and bargaining groups should be simplified and as easy to understand as possible. Communicate the risks of non-compliance for the agency and staff and collaborate to develop solutions that will reduce the risk.
Resources and References:
1The employer is liable for both its share of Social Security and Medicare taxes, and its employees’ share if not properly withheld from their wages.
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