United States: Fringe Benefits May Be Subject To Income Tax

As a new year commences, it's good for employers to pay attention to fringe benefits that fall outside the regular description of "wages" but may still be subject to income tax. If they are, employers are responsible for withholding. Let's consider some of the main areas.

Expense reimbursements

To be considered nontaxable, an expense reimbursement has to have a clear business connection that is adequately substantiated. Expense reimbursements apply to per diems and mileage reimbursements, and also advances (such as for work travel), allowances, direct payments to vendors and company credit cards.

Gifts and awards

To be nontaxable, length of service awards and safety awards have to be merchandise, not cash. They also have to be in the "meaningful presentation" category, such as formal recognition for years of service. The dollar limit is $1,600 per year for a qualified plan (meaning an employee achievement award plan must be in writing) and $400 a year for a nonqualified plan. Awards can't discriminate in favor of highly compensated employees, either in plan terms or results. Nor can awards be given for fewer than five years of service or more frequently than every five years.

Certain noncash awards aren't taxed: de minimis gifts, such as a holiday turkey or flowers an employee takes home from a table after a company event. In that case, the dinner itself, if it's part of a very occasional event, is considered nontaxable to the employee. Yet recurring dinners and meals could be taxable.

An infrequent prize or award of nominal value may not be taxable. Frequent awards are taxable, even if each one is small.

This can get tricky, because the IRS sets no dollar amount to define a nominal prize or award. If an employee receives an award that's taxable — say a $500 cash reward — he or she will have tax withheld on the $500 amount. If the employer grosses up the gift to pay the taxes on behalf of the employee, the entire amount would be considered income. For example, a $500 cash award that is grossed up would be $790.16 in income to a California employee who hadn't reached either the Social Security or California state disability insurance wage base limits.

Cash is cash

Cash awards, or cash equivalent awards, such as gift cards, are taxable. It doesn't matter how small the amount is. If a manager buys a bunch of $5 coffee cards and gives them to employees, for example, those cards are taxable to the recipients. The manager could give coffee tax-free, but not coffee gift cards. Most employers aren't aware of this rule, yet it is an IRS audit item. If a company doesn't tax the gift cards given to each employee, it may have to include the purchase in the manager's income, if the manager bought, was reimbursed for and distributed the cards.

Travel

Another award taxable to an employee is a travel award, say, for reaching a sales goal: "You've done a great job, so here's a trip to Hawaii." If such a trip is purely an award, with no work expected, it is 100% taxable to the employee.

To be tax-free, a spouse's travel also must have a bottom-line business purpose, which must be substantiated. If an employer pays for meals or other items for a spouse, those are taxable and included in the employee's pay.

Moving expenses

Moving expenses for work aren't taxable if they pass the time and distance test: The employee must move at least 50 miles from the current workplace location and be there at least 39-1/2 weeks. Qualified moving expenses include a onetime move of household goods and family members. Items such as house-hunting trips, temporary living expenses and trips from the old home to the new do not qualify.

Tuition benefits

Educational assistance programs for employees under IRC Section 127 aren't taxable for tuition, fees and school supplies such as textbooks. They have a $5,250 limit, and must meet one of the following:

  • They apply to an undergraduate or graduate degree.
  • The recipient isn't a candidate for a degree but is improving or developing capabilities.

Any amount that exceeds $5,250 is considered a fringe benefit and is taxable to the employee in the year incurred, except if it qualifies as a working-condition fringe benefit. In that case, it isn't taxable, even if the cost exceeds $5,250.

Sick pay

Sick pay provided by an employer or an employer's agent, generally during a temporary illness, injury or disability, is considered ordinary wages and is subject to withholding, although there is no Federal Insurance Contributions Act withholding after six months.

A third party that has insurance risk and makes payments for sick time other than as an agent of the employer is liable for federal income tax withholding and for the employee's part of Social Security and Medicare taxes, if requested by the employee. Those do not pertain if the third party has taken steps to transfer this liability to the regular employer.

Severance/separation pay

Severance pay is considered a form of compensation and must be reported on a Form W-2 as a lump sum payment or a continuation of wages. The same is true of separation pay.

Keep this in mind

Fringe benefits may be subject to Social Security and Medicare tax, federal unemployment tax, state income tax, state unemployment insurance, state disability insurance and local taxes. Failure to follow the proper tax rules for fringe benefits can result in the employer's having to amend Forms W-2 and also federal and state tax returns. It can also lead to penalties for failure to withhold, failure to pay and a trust fund recovery penalty, if applicable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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