Research suggests that more than 60 percent of U.S. workers would like to be able to access their earnings before their regularly scheduled paydays. Responding to this desire, many employers and their payroll providers now offer so-called on-demand pay arrangements that allow employees to receive their wages the same day they earn it.
While on-demand pay may be a valuable recruiting and retention tool for employers, the immediate availability of wages carries with it certain tax implications for employers that may not easily be avoided without updates to the tax laws and regulations.
What Is On-Demand Pay?
On-demand pay, sometimes referred to as "earned-wage access programs," is essentially a new alternative to payday lending—which some consumer advocates have criticized as predatory due to high fees and interest. Unlike payday lending, on-demand pay arrangements are not structured as a loan in the same way and carry fewer fees, if any at all.
On-demand pay services often require employees to specifically request access to wages through a mobile app (not to be confused with mobile apps offered by third-party companies that operate as payday lenders). Some on-demand pay systems only allow money to be deposited into a prepaid debit card issued by the payroll provider.
The IRS Constructive Receipt Doctrine
At the same time, this ease of access could trigger tax obligations due to the Internal Revenue Code's "constructive receipt" doctrine. Under this doctrine, wages are considered paid once the wages are "set apart for" the employee "or otherwise made available so that [the employee] may draw upon it at any time," regardless of whether the employee withdraws or spends the money. As the Internal Revenue Service (IRS) views it, the wages are paid once the employee has "unfettered control over the date on which they actually receive their wages."
When employers pay wages or an employee constructively receives wages, employers are obligated to withhold taxes and make deposits. Employers typically make the deposits on a weekly, bi-weekly, semimonthly, or other periodic basis, in accordance with their payday schedules. If on-demand pay is considered paid the day employees request that employers pay them, employers may not be meeting their deposit obligations or properly calculating withholdings if they continue to perform these tasks weekly, bi-weekly, etc.
Employers' Pay Options
In part to avoid this issue, some employers and payroll providers offering on-demand pay have sought to treat the on-demand pay as a short-term, low-to-no-interest loan from the employer to the employee. Alternatively, employers have placed restrictions on employees' use of on-demand wages, such as making only a portion of a day's wages available immediately.
However, it is not clear whether these efforts will be sufficient to satisfy the IRS under the constructive receipt doctrine. In the U.S. Department of the Treasury's March 2022 "Greenbook" outlining revenue proposals for the fiscal year 2023, the department identified that employees with access to on-demand pay may be in constant constructive receipt of their earned wages.
The department stated that employers that offer on-demand pay arrangements should "withhold and pay employment taxes on employees' earned wages on a daily basis." The department also highlighted a potential problem in that employers and third-party vendors are unlikely to make payroll deposits on a daily basis and some "ignore the constructive receipt issue entirely or treat the arrangement as a loan." The result either way, according to the department, is that "wages are treated as paid on regularly scheduled pay dates, rather than when constructively received."
As a result, the Department of the Treasury urged Congress to enact legislation to ease the administrative complexity. Specifically, the department proposed amending:
- Section 7701 of the Internal Revenue Code to define on-demand pay "as an arrangement that allows employees to withdraw earned wages before their regularly scheduled pay dates."
- Section 3401(c) of the Code to provide that on-demand pay be treated as a weekly payroll period.
- Sections 3102, 3111, and 2201 of the Code to clarify that on-demand pay is not a loan.
- Section 6302 of the Code to "provide special payroll deposit rules for on-demand pay arrangements."
These changes "would provide certainty and uniformity for taxpayers and would establish a uniform and administrable system for the IRS," the department said.
While on-demand pay has its benefits and is appreciated by employees, it could create tax liability exposure for employers and their employees. This exposure exists until legislative changes are made to change how on-demand pay is treated under the Internal Revenue Code.
Employers and payroll vendors may want to consider configuring on-demand pay systems to make payroll deposits on a daily basis, though this might present administrative complexity. Employers may otherwise want to consider placing restrictions on access to on-demand pay to avoid employees' constructive receipt of the wages.
Michael K. Mahoney is a shareholder in the Morristown, N.J. office of law firm Olgetree Deakins, a member of the firm's employee benefits and executive compensation practice group and the chair of the payroll tax and fringe benefits subgroup. Stephen Kenney, an attorney in the firm's Dallas office, advises clients on payroll and fringe benefit taxes. Zachary V. Zagger is the senior marketing counsel in the firm's New York City office. © 2022, Ogletree, Deakins, Nash, Smoak & Stewart, P.C. All rights reserved. Republished with permission.