In a recent private letter ruling (“PLR”), the IRS reiterated its general position that when an employer gives retiring employees a choice between cash and an otherwise tax-free benefit, both the cash payment and the benefit will be treated as taxable regardless of which alternative is chosen.

 

The PLR involved a state public school district that set up an early retirement incentive arrangement, which allowed each eligible employee to choose one of the following two alternatives when they provided notice to the school that they were electing early retirement:  (a) employer-paid retiree health care premiums up to a certain dollar-per-year threshold, or (b) a one-time payment based on the employee’s number of unused sick days plus a retirement bonus.  Generally, employer-paid health insurance premiums are tax-free to employees as well as former employees.  The IRS cited a prior IRS determination, which held that where an employee can choose between having unused sick leave credits paid in cash or applied to continue health plan participation, the employee is in “constructive receipt” of the value of the unused sick leave, which is thus includible in the employee’s gross income.

 

This PLR follows another recent PLR in which the IRS ruled that there is no taxable income to employees when their accumulated unused sick and vacation leave is automatically contributed toward their post-retirement health care insurance premiums.

 

These PLRs highlight that where a choice of taxable and nontaxable benefits is offered outside of a cafeteria plan, either choice will result in taxable income.  While it is generally permissible to apply unused leave at retirement toward the cost of tax-free health insurance in retirement, an employer should not allow employees a choice between cash and employer-paid benefits unless the employer intends to treat both such benefits as taxable.