You can reap tax benefits and minimize costs by knowing how fringe benefits are treated under the tax code. The basic rule is this: Fringe benefits are taxable compensation. But there are exceptions in the Internal Revenue Code to encourage businesses and individuals to do things that lawmakers deem to be good public policy.
As a result, some fringe benefits are exempt from tax, if certain rules are satisfied. Other benefits are tax deferred, with no income tax due until a later date. Or they are taxed at lower rates, such as capital gains on an employer’s stock.
Even fully taxed fringe benefits have a plus side: The tax that employees pay is less than what the cost would be if they had to pay for the benefits on their own. Usually, all employees must be eligible for a benefit for it to escape taxation. Some benefit plans cannot cover sole proprietors or partners, which is one reason many businesses incorporate. Most benefits also have limits on what can be paid to owner-employees and others.
Employers’ products and services qualify for breaks, within limits. They include: Price discounts. These are tax free if they are available equally to all employees and if the products are part of the business line in which the employees work. The discount cannot exceed the firm’s gross profit. On services, the discount may not exceed 20% of the price that customers pay (lower commissions for employees of a broker, for example). Spouses, children and retirees also can be offered the breaks.
Free services, such as rooms for hotel employees or trips for airline workers, are allowed. They must be available on an equal basis to all employees. Otherwise, high-paid staffers are taxed on the value of benefits they get. Reciprocity agreements with others in the same line of business are allowed.
Transportation and commuting benefits are popular, including the following: Company cars. The cost of providing a company car is taxable to the extent the car is available for personal use, except demonstrators for full-time salespeople.
Transit passes and tokens can be sold to employees at discounts of up to $130 a month. Or employees can be given cash up to $130, tax free.
Parking is tax free if worth up to $250 per month, even if the benefit is limited to high-paid employees. Anything above $250 per month is taxable income. Employees can be offered the option of taking cash instead of parking, but they will be taxed on the money.
Meals and entertainment are big benefits and have complex rules spelling out when they are taxable and when they are not.
Meals and lodging are tax free if provided on the firm’s premises and for the employer’s convenience, such as on-site meals for restaurant servers. They are 100% deductible by the employer, too. Farmers who incorporate can deduct the value of their meals and lodgings if they must live on the farm in the corporation’s residence and if 24-hour oversight is needed to run the operation.
Company cafeterias are tax free if open to wide classes of employees, not just top executives, officers, owner-employees and high-paids. Also, any revenue generated must be used to cover operating expenses.
Parties and picnics are tax free when a company sponsors them on an occasional basis.
Entertainment allowances are not taxable if they are used for business.
Education benefits can be considered taxable if the courses are not related to the employee’s job.
Tuition paid for job-related courses is tax free to employees and fully deductible by the employer. There is no limit on the amount. To be job related, a course must improve skills used on the current job. Classes to meet minimum requirements for a job or qualify for a new line of work, such as getting an MBA degree, usually are not job related.
Non-job-related courses, including undergraduate and graduate courses, are tax-free up to $5,250. Several requirements for the $5,250 exclusion must be met, including having a written reimbursement plan. And there’s a cap of 5% of total tuition payments per year to 5% of the owners of the company or to their relatives.
Health benefits subsidized by the employer are highly valued by most employees. The employer may pay all or a portion of the tab for health insurance or let employees pay some or all of it. It usually costs employees less to pay a group rate offered through their employer than to pay for coverage on their own. Benefits are not taxable, except in some self-insured arrangements.
Proprietors and partners may deduct 100% of the premiums paid for coverage for themselves and their families, thus treating them just like corporations. The same is true for owner-employees of S companies. They no longer have to hire a spouse as an employee and offer family medical coverage to take the full deduction for insurance.
Health savings accounts (HSAs) are another health insurance option now available to businesses and individuals. HSAs can be set up only by folks who have policies with high deductibles. The minimum allowable deductible is $2,500 for family coverage and $1,250 for self-only coverage. HSAs must also limit copayments on covered benefits to $12,700 a year for marrieds and family coverage and $6,350 for individual coverage.
HSAs are tapped to pay what basic coverage would have paid. Disability, dental, vision and long-term-care insurance are permitted. Seniors covered by Medicare can’t have HSAs. Nor can persons who can be claimed as someone’s dependent.
Write-offs for contributions are $6,550 for family coverage and $3,300 for self-only coverage. Participants born before 1960 can put in an extra $1,000 for 2014. The deduction can be claimed by both itemizers and nonitemizers.
Income earned within an HSA is not taxed to the HSA owner. Withdrawals are not taxed if used to pay for medical treatment of someone covered by the plan.
Payouts for other purposes are taxed and hit with a 20% penalty, unless made on or after reaching age 65 or because of death or disability. Unused amounts in HSA accounts are carried over to the following year. Individuals with medical savings accounts can roll them over tax free into HSAs.
Payins to HSAs are fully deductible by employers that make them on behalf of employees who do not have basic medical insurance protection. Contributions that are made by employers are tax free to the employees. Employers that offer HSAs must do so for all of their eligible workers.
HSA plans are worth checking into, especially by healthy folks, who can benefit from the tax-free compounding of their unused HSA payins.
Group-term life insurance is another popular benefit that employers can provide. The first $50,000 of insurance is tax free. Premiums for the amount above $50,000 are hit by income and Social Security taxes. But the tax paid is far less than what employees would pay for similar individual coverage. Policies must cover 70% or more of the staff, or only 15% of insureds can be top executives. Policies must be convertible if an employee quits, but employers need not offer any break on price. Policies given only to key employees are fully taxed to those employees. Retirees can be covered by company policies.
Companies that employ fewer than 10 workers have special rules: They must cover ALL full-time workers. Coverage must be a uniform percentage of pay or be based on tables that satisfy IRS rules. Physicals cannot be required, although employees can be required to fill out a medical questionnaire.
Group permanent insurance costs more, but it gives more to employees. An employee is taxed on employer-paid premiums that build up the cash value. But if changing jobs, the employee can buy the policy from his or her employer and pay future premiums.
Cafeteria plans let employees take cash or pick from a list of tax-free benefits, including health insurance. Other benefits that can be offered that way are group-term life, dependent care, 401(k) payins and longer vacations, but not parking, tuition, long-term care or employer-provided meals. In effect, employees can tailor fringe benefit packages to their needs. For example, they can buy extra health insurance or skimp on that and fulfill other needs.
Flexible spending accounts are a narrow variety of cafeteria plan. Employees agree to reduce their pay, with the reduction put into accounts that they can tap for medical and dependent care expenses during the year. Employees pay less income tax because the expenses are paid with pretax dollars. Employers save, too: They pay less in Social Security and Medicare taxes because employee salaries are reduced. The maximum salary reduction for medicals is $2,500.
There is one risk worth noting: A “use it or lose it” rule may apply. As a general rule, employees forfeit any money remaining in their accounts at year end. But firms can amend their plans to either give employees until March 15 of the following year to empty their accounts or let them carry over as much as $500 of unspent funds.
Tax-qualified retirement plans are another key area for fringe benefits. Qualified plans offer three tax breaks that make them attractive: deductible payins, tax-free income buildup and low tax payouts.
Firms have three options: pension plans, profit sharing and 401(k)’s. Their plans can be used to give workers a stake in the firm by giving them stock or options to purchase stock in the company. Or they can be used to encourage employees to save.
Annual contributions by employers are required with pension plans. They are not required with profit sharing plans because contributions obviously depend on whether there are any profits to share.
Retirement payouts are specified under pension plans, often based on a percentage of pay for the final year or series of years of employment. Profit-sharing and stock purchase plans don’t promise a specific benefit. Employees get the current worth of the company contributions to the plan. Most pension plans are insured by a government agency, but profit-sharing plans are not.
Who gets coverage is similar under pensions and profit-sharing plans. There are limits on favoring owners, officers and high-paids. Company payins can be tied to pay. But they must cover most workers, including those in other companies that are owned by the same people. If most of the plan benefits go to top employees, faster vesting is required.
401(k) plans are a growing retirement option for companies, replacing older alternatives in which employers put up most of the money. Salaries or bonuses are diverted into an account and invested in any or all of the investments on a menu (usually a choice of mutual funds) selected by the plan. Employees choose which options to invest in and can shift savings from one option to another.
Payins are free of income tax, but Social Security and Medicare taxes apply. Employees can contribute as much as $17,500 of annual pay—$23,000 if they were born before 1965. Employers can match employee payins, adding incentive to participate.
Payins by high-paids—those who make more than $115,000 a year or own more than 5% of the company or are related to someone who does—are capped. The amount high-paids can set aside depends on the level of participation of others in the plan. High-paids can put in up to 125% of the percentage of pay that those making less than $115,000 contribute. Or up to 2% of pay more than lower-paids contribute, so long as that isn’t more than twice what lower-paids set aside. For simplicity, companies can use the prior year’s percentages for lower-paids. Any excess deferrals must be returned as taxable income to high-paids.
Rank-and-file participation is vital for a successful 401(k), although nondiscrimination rules have been eased a bit since 401(k)s started. Contributions by highpaids needn’t be tied to what others do if the employer matches at least the first 3% of pay plus one-half of the next 2% that lower-paids put in. Or firms can put in 3% for all employees making less than $115,000.
Tax-exempt organizations can have 401(k)s, but state and local governments cannot.
Small businesses have an option when it comes to setting up tax-qualified retirement plans. They can simply adopt a master or prototype plan approved by the IRS. There are many options. They are offered by life insurers, mutual funds, banks, benefit advisers and others. Be sure that the sponsor will amend your plan to keep current with rules and regulations as they change. That’s a chore that small businesses are ill equipped to do on their own.
To qualify, firms must have 100 or fewer employees. The plans are called SIMPLEs, which stands for Savings Incentive Match Plans for Employees. SIMPLEs require a match for employees paid in wages $5,000 or more in 2012, 2013 and 2014. The match cannot be more than the smaller of 3% of pay or what the employee puts in. SIMPLEs can be set up as individual retirement account (IRA) arrangements or 401(k) plans.
In SIMPLE plans, employee contributions are capped at $12,000 per year. Employees who are 50 or older in 2014 can contribute an extra $2,500. Unlike 401(k)s, payins of high-paids don’t depend on what lower-paids contribute.
Plans for nonprofits include more than 401(k)s. Employees can also get 403(b) annuities, which many teachers have. The maximum payin in 2014 is $17,500—$23,000 for those born before 1965.
Company athletic facilities on company premises are not taxed when all employees can use them.
Day care is tax free up to $5,000 a year when it’s offered to everyone in the company.
Help with retirement planning is tax free for employees if the employer sponsors a retirement plan. Such help may also include financial counseling.
Low-interest loans can be tricky. Employees are deemed to have received income generally equal to the interest they don’t pay. They may get offsetting deductions for phantom interest paid to the employer, depending on whether the loan is for investment, business or a home mortgage. The tax impact on employers must be weighted, too. Income that employees could earn with loan proceeds might generate taxable income for employers.
Gifts are not taxed if they are inexpensive and are given for holidays, birthdays, etc.
Achievement awards are tax free if they’re given for length of service or reaching safety goals. The awards must be tangible personal property, not cash, and must not cost the employer more than $400—or $1,600 for awards made under a written plan that does not favor high-paids.
The Future of Fringe Benefits
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The Future of Fringe Benefits is a debate in Washington over the role of government, deficits, tax cuts and reforms involving fringe benefits. Tax cuts remain a major inducement from Congress to encourage private actions, and fringe benefits are no exception. In 1996, for example, SIMPLEs and tax breaks for long-term care and adoptions were enacted. And starting in 2004, Health Savings Accounts were allowed. Incentives are often a substitute for programs the government cannot afford. Thus, breaks for long-term care will ease some of the burden facing Medicare as baby boomers age. Favorable treatment for benefits is a tax cut in disguise for employees and employers in a position to use them. Reducing the number of tax benefits could save federal revenue that could be used to reduce tax rates. That is at the heart of the discussion about a flat tax and tax simplification. How this unfolds will affect all of us in our personal lives and in our businesses. We will keep you ahead of the pack on these and many other developments in Twilley Rommel and Stephens Newsletter.