IRS holds unfunded vacation benefits are wages

Tax Hot Topics newsletterThe IRS ruled in PLR 201947010 that certain “unfunded” vacation benefits and discretionary supplemental distributions paid from voluntary employees’ beneficiary association (VEBA) are both wages for federal employment tax purposes.

Under the VEBA, participating employers are required to contribute monthly a specified amount for each hour worked by each of their employees. The VEBA maintains records of the payments received with respect to the work performed by each employee and credits these payments to a vacation account for each such employee. The amounts credited to the vacation accounts for work performed from March 1 of each year to the last day of February of the following year are distributed twice a year – on or about July 1 and Dec. 1 of the succeeding calendar year, by checks or direct deposit for any employees who request to receive their vacation benefits.

The VEBA also has an unfunded reserve that is used to provide vacation benefits to the employees of participating employers who fail to make their required contributions. The unfunded reserve is funded by interest earned on deposits in the VEBA, delinquent employer fees, and forfeited vacation benefits. Before amounts can be paid out from the unfunded reserve, the VEBA must determine that contributions are uncollectible from the employers at issue and that there is no collusion between the employers and affected employees. In addition, affected employees must substantiate their hours worked to the VEBA in order to receive payment. Per an agreement with the VEBA, delinquent employers treat benefits paid out from the unfunded reserve as wages and withhold employment taxes on their employees’ cash wages unrelated to the vacation benefits paid from the VEBA.

In addition, the VEBA makes additional, discretionary payments from a plan’s surplus funds as supplemental distributions to participating employees in proportion to the amounts they normally would receive as vacation benefits for hours worked.

The VEBA requested the IRS to rule that the payment of the unfunded vacation benefits and the supplemental distributions are not wages, and therefore they are not subject to employment tax withholding or Form W-2 reporting. The VEBA asserted that the unfunded vacation benefits are paid from amounts that have been previously taxed as wages to the recipients so should not be taxed again as wages. The IRS disagreed with the VEBA’s position and determined that both the unfunded vacation benefits and the supplemental distributions are wages subject to employment tax withholding and reportable on Form W-2. With respect to the unfunded vacation benefits, the IRS noted that when an employer fails to contribute to the plan, no transfer of property occurs under Section 83, and there is no actual or constructive payment to the employee. For amounts that have not been actually or constructively paid, there are no taxable wages that would result in double taxation according to the VEBA’s argument.

With respect to the supplemental distributions, the IRS noted that the amount of such distributions is determined based on the services employees provided to their respective employers, and therefore, concluded the supplemental distributions are wages. In addition, the IRS noted that employees do not receive a substantially vested interest in the excess reserve funds prior to actual payment of the supplemental distribution. Accordingly, the supplemental distributions are not taxed under Section 83 and are, instead, taxable at the time of actual or constructive payment.

The IRS also concluded that the VEBA, and not the participating employers, is responsible for withholding the employment taxes and reporting the payments as wages on the employee-recipients’ Form W-2s because the VEBA has control of the payment of the unfunded vacation benefits and supplemental distributions within the meaning of Section 3401(d)(1).

Finally, the IRS concluded that the payment of the unfunded vacation benefits and supplemental distributions does not affect the exempt status of the VEBA under Section 501(c)(9) – concluding that those payments were permissible “other benefits” under the applicable regulations.
Jeff Martin
Washington National Tax Office
T +1 202 521 1526

Keith Mong
Managing Director
Washington National Tax Office
T +1 202 521 1554

James Sanchez
Senior Associate
Washington National Tax Office
T +1 202 861 4107
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