Structure a Tax-Smart PTO Donation Program

During COVID-19 pandemic, employees’ interest in paid leave programs increased dramatically. While these programs are nothing new, it was relatively rare to see them on the menu of employee benefits until recent months. Some paid leave donation programs allow employees to donate leave to charitable causes—most recently, the war in Ukraine. Often, however, paid leave donation programs allow employees to donate paid time off to a pool that can be accessed by fellow employees who need time off work and have exhausted all of their own PTO. PTO donation programs can be a powerful employee retention tool—but they can also be complicated to administer in a tax-friendly matter, however, and it’s important for small business clients to know all the details to avoid an unpleasant future tax surprise.

Employee PTO Donation Programs: The Basics

The basic concept of a PTO donation program is simple. Employees with leftover PTO can be given the option of donating the excess leave to a pool for fellow employees. However, under most circumstances, the value of the paid time off would count as taxable income to both the employee who originally earned the PTO and the employee who received the PTO donation.

There are two primary exceptions to the general rule that the PTO will be taxable: medical emergencies and natural disasters.

Negative tax consequences for the donor can be avoided if the employee who receives the donation has a medical emergency or needs to care for a child, spouse or parent with a medical emergency. Qualifying medical emergencies are generally defined to include illnesses or medical conditions that require the employee to miss a protracted time at work (whether to receive treatment or care for a family member). The plan should specify any limits on the amount of leave that can be taken by any single recipient. Detailed guidance on the IRS rules can be found in Revenue Ruling 909.

Similarly, if the recipient was adversely impacted by a federally-declared natural disaster, the donor won’t be taxed on the value of leave donated through the program. The employee is considered to be adversely affected by the major disaster if the disaster caused severe hardship to the employee or a family member and the employee must miss time at work because of it. After a disaster, the employer should establish a time frame during which the leave bank will accept donations and the employer should have a policy in place for determining how much donated leave the employee will be permitted to use. Detailed guidance on the IRS rules can be found in Notice 2006-59.

In both circumstances, the cash value of the donated PTO will count as taxable income to the recipient (and is subject to FICA and FUTA taxes).

The employer should exercise caution when structuring any PTO donation program. Any PTO donation program should be in writing and administered in a fair and non-discriminatory manner. It’s also important that the recipient never be permitted to receive the cash value of the donated PTO .

Charitable Leave Donation Programs

After the events caused by the pandemic and the war in Ukraine in recent months, many employees may be interested in participating in a charitable leave donation program rather than simply forfeiting any unused PTO. It’s important that employers have all relevant information as to the basic mechanics of these programs before offering the option. First, the employer must determine who is eligible to participate and in what increments leave can be donated (hours, days or weeks).

The employer can also choose the IRC Section 170(c) charity that will receive donations, or may permit individual employees to decide themselves. Then, the employer establishes an open enrollment period during which employees complete an election form provided by the employer and specify how much leave they wish to contribute.

The employer determines the cash equivalent value of the leave that is donated (based on the employee's compensation and the amount of leave donated) and contributes that cash amount to the charity. Contributions are not taxed to the employee, and the employer can elect to either deduct the contributions as charitable donations or business expenses (the donating employee is not entitled to a charitable contributions deduction, however).

Conclusion

In an environment where many employers are considering adopting non-traditional employment benefit programs, a PTO donation program might be a viable option. PTO donation programs can increase employee morale and provide a measure of flexibility for employees who might be experiencing unforeseen circumstances or simply want to put their unused PTO dollars to good use. However, it’s always important to pay close attention to the details to make sure the client gets it right with the IRS.