The Internal Revenue Service is backing away from a ruling that could have required immediate taxation of accumulated vacation, sick leave and other benefits paid to employees of state and local governments and tax-exempt organizations.
Although the IRS now says it never had any intention of taxing such benefits, union leaders say the agency's clarification on Wednesday could benefit more than 14 million workers.O. Donaldson Chapoton, assistant secretary of the treasury for tax policy, said Wednesday that pending IRS regulations will spell out that "bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay and death benefits are not deferred compensation subject to" tax under Section 457 of the tax code.
Chapoton outlined the government's position in a letter to Rep. Ray McGrath, R-N.Y. McGrath, a member of the House Ways and Means Committee, has been fighting an earlier IRS interpretation that left open the door to taxation of certain employee benefits at the time they were accrued, rather than when they were used.
"It was never the intention of Congress to allow the taxation of bona fide employee benefits," McGrath told reporters in releasing Chapoton's letter.
The change, he said, "signifies the fact that the IRS will not be picking the pockets of these kinds of taxpaying employees."
The debate centers on a 1978 law that allowed employees of state and local governments to take part in deferred-compensation retirement plans. In 1986, Congress brought employees of universities, non-profit hospitals and other tax-exempt organizations under that law.
The IRS traditionally considered immediately taxable only "elective" forms of deferred compensation, such as salary that a worker voluntarily postponed receiving. "Non-elective" compensation, where there is no option to receive it immediately, was taxed when received, rather than when it was earned.
In 1987 the IRS issued a notice that was widely interpreted as requiring immediate taxation of "non-elective" compensation and extending that definition to such basic benefits as vacation and sick pay.