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Two recent Revenue Rulings, Rev. Ruls. 2009-31 and 2009-32, address contributions of unused paid time off (PTO) to 401(k) plans. A PTO plan is a sick and vacation leave plan under which an employee can take paid leave whether or not the employee is sick or injured.

For example, suppose an employer establishes a PTO plan that pays employees for up to 240 hours of PTO per year (with the maximum based on years of service). The plan otherwise qualifies as a modified sick and vacation leave plan that is exempt from Code §409A. The plan operates on a “use it or lose it" basis, so there are no carryforwards of unused PTO to future years. However, the employer will contribute the dollar amount of an employee’s unused PTO (to the extent permissible under Code §415 and other limitations) to the employee’s profit sharing account in the employer’s 401(k) plan. For example, if an employee, earning $25/hour, used 210 of 240 available PTO hours for 2009, the employer would contribute $750 ($25/hour times 30 hours) to the employee’s profit sharing account.

The Rulings examine in depth 6 different scenarios as a means of demonstrating various legal principles dealing with the relationship of PTO plans and 401(k) plans. Between them, the Rulings analyze several different types of PTO plans, including plans which do or do not allow carryover of unused amounts, plans which contribute to an employee’s account (or pay the employee in cash) for unused amounts at the end of a year, and plans which contribute unused PTO credits to an employee’s account (or pay to the employee in cash) upon employment termination.

Here are some of the key conclusions from the Rulings:

• The contribution of unused PTO to a 401(k) plan, following specific limitations: (1) does not adversely affect the plan’s qualification, (2) does not cause the amounts so contributed to be taxable to the participant, and (3) does not subject the PTO plan to the limitations of Code §409A as something other than a bona fide sick and vacation leave plan.
• If the employee has the option to receive the unused PTO amount in cash or to allow the employer to contribute it to the 401(k) plan, the plan contribution is an elective deferral. As such, it is subject to the ADP test (unless the plan is a safe harbor plan) and the 402(g) limit. The PTO-derived elective deferral is included in the employee’s compensation, the same as other elective deferrals.
• If the employee does not have the option to receive the unused PTO amount in cash (i.e., the employer will contribute it to the plan on the employee’s behalf regardless of the employee’s wishes), the contribution is a nonelective contribution. As such, the plan tests the contribution under Code §401(a)(4) as a nonelective contribution. The plan will almost surely have to do the general nondiscrimination test, because the PTO contributions for different employees will not be uniform. The nonelective contributions are not compensation for plan purposes and are not included in the 402(g) test.
• To the extent a plan, under its terms, pays an employee in cash for unused PTO (notwithstanding the fact that the employee may have been able to defer the amounts), the payments are income in the year of distribution, rather than in the year the employer credited the PTO under the plan.
• Suppose, in 2010, an employer with calendar year plans contributes to the employer’s 401(k) plan amounts subject to an employee’s cash or deferred election for 2009 unused PTO. If the plan credits the amounts as of a date in 2009, and the employer makes the contribution no later than 30 days after the extended due date of the employer’s return, the contribution will be a 2009 annual addition (counted in the 2009 ADP test). Otherwise, the contribution will be a 2010 annual addition.
• The new 415 post-severance compensation limitations apply to the PTO plans. The plan document will determine whether the plan counts PTO paid after severance of employment. The plan can count it only if the plan would have counted it as compensation if paid prior to severance and only if paid by the later of 2½ months after employment termination or the last day of the limitation year in which employment terminates.

Comment: The Rulings raise a fascinating scenario involving PTO. Suppose an employee severs employment December 28, 2009, with $3,000 in unused PTO. The employer will contribute the PTO amount to the plan (as a nonelective contribution) as of January 31, 2010, to the extent consistent with the 415 limit, and otherwise will pay the amount to the employee. The employee will have no other 2010 compensation. The maximum amount the employer can contribute as a nonelective contribution (which is not compensation for plan purposes) would be $1,500. The employer would then pay the employee $1,500 as compensation. If the employer were to contribute more than 50% to the plan, the contribution would exceed the employee’s compensation and hence would violate the 415 compensation limit. The potential 415 violation is not an issue if the employee has the choice of receiving the PTO in cash or deferring it to the plan, because the amount subject to the cash or deferral election would be compensation for plan purposes.

The 2009 ERISA Workshop will address the PTO issue, as well as other recently issued current developments from the IRS and the DOL.
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