For the Texas franchise tax taxable-capital component, must accrued but unused vacation pay be added back to surplus, or does it count as a debt that is excluded?

Plain-English summary

This is an internal Tax Policy memorandum to the Audit division about whether a taxpayer's accrued unused vacation pay (and personal/sick time) should be added back to taxable capital as surplus for the (pre-2008) franchise tax. The controlling idea is the debt test.

• Surplus includes estimated liabilities. An accrual that is only an estimate - not a fixed obligation - falls within the definition of surplus under Tax Code Section 171.109(a)(1) and is therefore part of taxable capital. The memo quotes Comptroller's Decision No. 30,118, which held that a vacation-pay accrual resting on assumptions (that all employees will use all accrued vacation, and that wage rates will stay constant) is an estimated liability and was properly assessed.
• The debt test. A liability is a debt - and excluded from surplus - only when it is certain as to both amount and time. If the accrued amount is not a sum-certain obligation, it is surplus.
• Why these accruals failed. Exempt employees forfeit vacation not taken by their anniversary (there is no carryover), so the obligation may never come due; and the payout can be based on wage rates that change between the accrual date (fiscal year-end, March 31) and the time the vacation is actually taken or reimbursed. Both features make the accrual not definitive/sum-certain. The personal/sick pay was even more uncertain.
• Conclusion. The memo concluded the taxpayer's vacation accruals do not meet the debt test, supporting the audit's add-back to taxable capital.

Note: This is a staff memo responding to an auditor's question; it gives the auditor "additional direction" rather than issuing a formal ruling to the taxpayer, and it points to Comptroller's Decision Nos. 30,118, 30,563, and 30,679 as the agency's guidelines on vacation accruals.

Currency note: This applies the pre-2008 taxable-capital/surplus rules, replaced by the current margin tax (House Bills 3 and 3928) effective January 1, 2008. Treat as historical.

What this means for you

Employers accruing vacation and sick pay

Booking a vacation accrual on your financial statements did not automatically keep it out of Texas taxable capital. If employees could forfeit unused vacation, or if the eventual payout floated with future wage rates, the accrual was an uncertain estimate - surplus - and got added back. A "use it or lose it" policy actually cut against debt treatment because it made the obligation contingent.

Accountants and tax professionals

Run each accrued compensation liability through the debt test: is it certain in both amount and time? Forfeiture provisions, anniversary deadlines, and variable wage-rate payouts all defeat sum-certainty and push the accrual into surplus under Section 171.109(a)(1). Personal/sick pay that is discretionary or forfeitable is even harder to defend as debt.

Common questions

Q: Is accrued vacation pay always added back to taxable capital?
A: Not always - only when it fails the debt test. If the accrual is not certain as to both amount and time, it is surplus and added back.

Q: Why did a "no carryover" policy hurt the taxpayer here?
A: Because employees could forfeit unused vacation, the obligation was not certain to be paid, so it was an estimated liability (surplus) rather than a fixed debt.

Q: Does a wage rate that changes before payout matter?
A: Yes. If the payout is based on wages that can change between accrual and payment, the amount is not sum-certain, so the accrual is surplus.

Q: Where are the agency's guidelines on this?
A: Comptroller's Decision Nos. 30,118, 30,563, and 30,679 (with 26,424 and 30,509 cited on estimated-liability surplus treatment).

Citations and references

Statutes and decisions:

• Tex. Tax Code Sec. 171.109(a)(1) (definition of surplus; estimated liabilities are included)
• Comptroller's Decision No. 30,118 (vacation accrual resting on assumptions is an estimated liability and is surplus)
• Comptroller's Decision Nos. 30,563; 30,679 (agency guidelines on vacation accruals)
• Comptroller's Decision Nos. 26,424 (1991); 30,509 (1993) (estimated-liability surplus treatment)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200308085L

Original ruling text

DATE: August 29, 2003

TO: Ron Robinson, Audit

FROM: Jerry Bobbitt, Tax Policy

SUBJECT: Vacation Accruals

Comptroller Decision Nos. 30,118; 30,563; and 30,679 are probably the best
sources of the agency's guidelines concerning vacation accruals.

Here is an excerpt from the conclusions of law in Comptroller Decision No.
30,118:

As I see it, there are two problems with this argument. First, there is a
chance, however remote, that employees will not use all of their accrued
vacation during the coming calendar year, thereby losing their entitlement to
that vacation pay. Second, Petitioner accrues vacation pay based upon its
employees' current (year-end) salaries or wages, which may or may not be the
same when the employees take their vacation the following year. Thus,
Petitioner's vacation pay accrual is an estimate based on the following
assumptions: (1) that all employees will use all their accrued vacation from
the previous year in the coming year, and (2) that all employees' salaries or
wages will remain constant from the time the vacation pay is accrued through
the time it is actually used. As an estimated liability, Petitioner's vacation
pay accrual falls within the definition of surplus under Section 171.109(a)(1)
and, therefore, was properly assessed in the audit. See Comptroller's Decision
Nos. 26,424 (1991) and 30,509 (1993).

The above decision along with the subsequent decisions addressing vacation
accruals approach the issue by determining if the vacation accrual booked
reflects the amount that will be realized by the corporation when it has to
satisfy the obligation. With this in mind, I have a few questions/comments
based on the information you forwarded. That information stated the following:

FACTS

Taxpayer accrues unused vacation and personal/sick time earned by eligible
employees each year ended on March 31st. This amount is calculated basing on
actual hours earned and actual hourly rate prevailing on the last date of the
fiscal year for each employee. Taxpayer's written policy states that:

PAID VACATION

Exempt employees must schedule their vacation prior to the end of their
anniversary year. There is no "carry over" of vacation. Non-exempt regular
full-time employees may request reimbursement for unused vacation at the end of
their anniversary year.

The above information indicates that exempt employees are subject to losing any
vacation if it is not taken prior to the employee's anniversary. If this does
reflect the corporation's practice, then the amount accrued for these employees
is not a definitive/sum certain obligation.

. . . .

Also, what about those exempt employees who get a raise after March 31 and
decide to leave the corporation before their anniversary date. First, will
they be paid for the unused vacation prior to their anniversary date? If so,
will the payment be based on their current wages or the amount accrued at March
31?

With respect to those employees that can request reimbursement of their
vacation pay, how does the corporation handle these payments if an employee has
a pay raise between March 31 and the date it gets the actual payment? Is the
amount based on the current pay? If so, then the amount accrued would not meet
the sum certain test.

From what I've seen, it would appear that the taxpayer's vacation accruals do
not meet the debt test. Hopefully, the above comments give the auditor some
additional direction to work from. Please let me know if you have any
questions.

From Ron Robinson, August 1, 2003

The taxpayer is questioning the add back of accrued vacation to taxable
capital. Would you kindly give me a response based on the facts stated in the
attachment.

Thank you.

From Taxpayer

In regard to add-back of accrued vacation of the three years under audit, I
deeply agree with that "compensation and benefit are included in surplus to the
extent they are not debt as of the accounting year end upon which the return is
based".

FACTS

COMPANY A accrues unused vacation and personal/sick time earned by eligible
employees each year ended on March 31st. This amount is calculated basing on
actual hours earned and actual hourly rate prevailing on the last date of the
fiscal year for each employee. COMPANY A's written policy states that:

PAID VACATION

Exempt employees must schedule their vacation prior to the end of their
anniversary year. There is no "carry over" of vacation.

Non-exempt regular full-time employees may request reimbursement for unused
vacation at the end of their anniversary year.

PERSONAL/SICK PAY - is provided for the employee's judicious use and are not
intended as vacation time.

Exempt employees - Personal/sick pay cannot be carried over from one year to
the next and all sick time in an employee's account will be forfeited at the
time of termination.

Non-exempt regular full-time exempt employees - Unused personal/sick pay at the
end of the employee's anniversary year cannot be carried over. Unused
personal/sick pay is forfeited at time of termination.

As I understand that a debt is actual when it is certain as to both amount and
time. The vacation pay accrual of COMPANY A was an actual debt because (1) the
amounts are accurate and known to be payable to the employees once earned and
(2) there was a time limit within which the employee had to take the vacation.
However, the portion of personal/sick pay is to be included in surplus due to
its nature of uncertainty.

For your review, I faxed pages of COMPANY A Employee Manual and last page of
accrued vacation, personal/sick time schedule of year 2000, 2001, & 2002.
Please kindly revise your tax adj summary and let me know if you need further
information.