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When Is a Sick or Vacation Leave Plan Bona Fide?

Linda Segal Blinn

School districts with an unused accumulated leave procedure may consider monitoring the IRS’ 457 regulatory project, which, in part, would define what constitutes a bona fide vacation leave or sick leave plan. If a sick or vacation leave plan is considered “bona fide” as defined in the proposed 457 regulations issued on June 22, 2016, then the leave plan would not be considered a deferral of compensation. However, if a vacation or sick leave plan does not satisfy the proposed regulatory criteria, that plan would be considered a nonqualified arrangement for the deferral of compensation and thus subject to Internal Revenue Code Section 457(f).

Section 457(f) governs deferred compensation arrangements sponsored by governmental employers (including public schools) and other tax-exempt entities. Among other requirements, Section 457(f) provides that amounts under a 457(f) deferred compensation arrangement are included in the employee’s gross income when those amounts are no longer subject to a substantial risk of forfeiture (regardless of whether the individual took a withdrawal from the leave plan).

According to proposed Treas. Reg. §1.457-11(f)(1), whether a sick or vacation leave plan will be considered bona fide will be based on the facts and circumstances demonstrating that “the primary purpose of the plan is to provide participants with paid time off from work because of sickness, vacation, or other personal reasons.” Relevant facts and circumstances would include:

  • whether the amount of leave provided could reasonably be expected to be used in the normal course by an employee (before that individual stops providing services to the eligible employer), barring unusual circumstances;

  • whether the employee is able to exchange unused accumulated leave for cash or other benefits (including nontaxable benefits and the use of leave to postpone the date of termination of employment);

  • the extent to which there are restraints on an employee’s ability to accumulate unused leave and carry it over to later years in circumstances in which the accumulated leave may be exchanged for cash or other benefits;

  • the amount and frequency of any in-service distributions of cash or other benefits offered in exchange for accumulated and unused leave;

  • whether any payment of unused leave is made promptly upon severance from employment (or instead is paid over a period after severance from employment); and

  • whether the leave program (or a particular feature of that leave program) is available only to a limited number of employees.

If a sick or vacation leave plan is considered bona fide, leave amounts allocated to an employee’s account would not be considered a deferral of compensation.   

As currently proposed, a “bona fide plan” of sick and vacation leave may not meet the needs of public school districts and their students. If an educator uses the full amount of leave allotted each year, then students would be taught by a substitute teacher for classes from which the educator was absent. Recognizing that the proposed criteria may not be a good fit for all employers, the IRS noted in the preamble to the proposed 457 regulations that additional refinement may be necessary:

“The Treasury Department and the IRS recognize that eligible employers sponsor a wide variety of sick and vacation leave plans and that additional rules on more specific arrangements or features of these plans may be beneficial. Accordingly, the proposed regulations provide that the Commissioner may issue additional rules regarding bona fide sick or vacation leave plans in revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin, as the Commissioner determines to be necessary or appropriate.”

The IRS’ regulatory initiatives include issuing final 457 regulations, which may shed additional light on “bona fide” sick and vacation leave plans. The IRS will be assessing letters submitted during the comment period (closed on Sept. 20, 2016) and testimony during the October 2016 hearings. When the IRS issued the proposed regulations in June 2016, the IRS noted that they generally were not currently effective and would apply to calendar years beginning after the date of publication of the final IRS regulations.
Additional information, including the status of the 457 regulations, is available here.
Linda Segal Blinn, J.D.*, is vice president of Technical Services for Tax-Exempt Markets at Voya Financial. In this capacity, Blinn leverages over 25 years of experience administering and designing defined contribution plans to provide general legislative and regulatory information to assist public and non-profit employers in operating their retirement plans.

This material was created to provide accurate information on the subjects covered. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matters addressed in this document. The taxpayer should seek advice from an independent tax advisor.

* Linda is not a practicing attorney for Voya Financial.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.