I have a client who wants employees to take a one time cash payout of their unused sick time and allow the employees to make deferrals into the plan from the payout. Can they do this?

Yes.

Thank you for your response. Do you have a citation for this?

YOu might want to look at TAM 9635002, November 9, 1995 and PLR 19940043.

thank Kirk. I didn't get a chance to respond until this am.

Make certain that the plan document permiots what you want to do. You might need a special amendment.

If it is going to be a cash payment that is additional W-2 compensation, then it is possible that the plan document already permits the employees to defer a portion.

Check the plan's definition of "Compensation" for purposes of accruals/elective deferrals and see if it includes all uses a definition that generally includes all taxable compensation, all W-2 compensation, or all income subject to withholding and that it doesn't exclude special payments like bonuses, ect.

Then check your current election form and see how it tracks with with the plan definition (i.e., are employees electing to apply the deferral rate to all "Compensation" or just regular pay?)