What is it?
In today's competitive job market, an attractive employee benefit package can be a useful tool to help you recruit new employees and retain those who are crucial to your company's success. In addition, the tax benefits you can receive by offering employee benefits are twofold: First, the costs of providing employee benefits are sometimes tax deductible as a trade or business expense. Second, the value of the benefits may be excludable from your employees' gross income, reducing your taxable payroll. A reduction in your taxable payroll decreases your matching payments of Social Security and Medicare taxes, as well as unemployment taxes.
Types of employee benefits
Employee benefits can come in either the form of cash or noncash benefits, also known as fringe benefits. Both types of benefits can help your employees meet needs that otherwise could not be met. In addition, providing your employees with benefits can result in significant tax savings, as noted above, provided that the value of the benefits are deemed "reasonable" in the eyes of the IRS.
IRS rules for deductibility of benefits
In order to deduct the cost of employee benefits:
- The expense must be an ordinary and necessary expense of your company's trade or business
- You must pay or incur the expense during the tax year in which you deduct the expense
- The expense must be in connection with a trade or business that you conduct
IRS rules for reasonableness
In addition, the value of the benefits must be reasonable. The IRS considers the following factors when determining reasonableness:
- The corporation's size and financial condition (a large company that is financially stable can justify a large increase in compensation, while a small company that is financially unstable cannot)
- The role of the employee (employee's contributions to the success of the company)
- Whether or not you pay the compensation according to a structured program that you apply on a consistent basis
- The employee's compensation in comparison with what similar companies in similar industries pay for similar services
- Whether the company encourages an employee/shareholder, who is able to set his or her own compensation, to disguise nondeductible dividends as compensation
Tip: The IRS considers all of the elements of an employee benefits package (salaries, bonuses, fringe benefits, and retirement benefits) when it determines whether or not the compensation is reasonable.
Employers are generally not required to offer coverage, but those that don't may be subject to a penalty tax. In 2019, the penalty tax applies to employers with 50 or more full-time equivalent employees (FTE) who do not offer qualifying health coverage to at least 95% of their FTEs and dependent children up to age 26 (spouses are not considered dependents and coverage does not have to be offered to spouses of FTEs). The penalty is assessed to eligible employers that do not offer coverage if at least one FTE receives a federal premium tax credit or cost-sharing subsidy for coverage purchased through a health insurance Marketplace. In 2019, the employer penalty is $2,320 per FTE divided by 12, excluding the first 30 FTEs.
In addition, if an eligible employer offers health insurance that is not considered affordable or does not provide minimum value, the penalty for each month is $3,480 divided by 12, for each FTE receiving a premium tax credit, up to a maximum of $2,320 per FTE, excluding the first 30 FTEs, divided by 12. Health insurance provides minimum value if it pays for at least 60% of covered health care expenses for a standard population. Health insurance is affordable when the cost of coverage is no more than 9.86% of an employee's family income.
Employers with more than 200 full-time employees that offer health insurance must automatically enroll new full-time employees, subject to a waiting period of no longer than 90 days.
Group health plan coverage requirements
Group health plan requirements under the health-care legislation directly apply to insurers. However, most of these provisions are incorporated by reference into ERISA and the Internal Revenue Code, extending their application to employers offering group health insurance. Some important group health plan requirements include:
- Group plans that offer coverage for dependent children must extend the age for dependent coverage to age 26. For plans in existence prior to March 23, 2010 (the date of legislative enactment), the extension of dependent coverage applies only if an adult child is not eligible to enroll in any other eligible employer-sponsored health plan.
- Coverage for a plan participant cannot be rescinded except for fraud or intentional misrepresentation, and plans may not impose pre-existing condition exclusions on any plan participant or beneficiary.
- Plans may not impose lifetime limits on the dollar value of essential health benefits for plan participants and beneficiaries. Essential health benefits are intended to include those benefits customarily provided under a typical employer health plan, as defined by the Secretary of Health and Human Services. Also, plans cannot impose annual coverage limits for essential health benefits.
- Most preventive care services and immunizations recommended by the U.S. Preventive Services Task Force will not be subject to deductibles, co-pays, and co-insurance. (Plans in existence on or before March 23, 2010, are exempt from this provision.)
- Most employers must meet certain reporting and disclosure requirements, which include providing a summary of plan benefits and annual reports to participants; reporting annual enrollment and claims practices to the Secretary of Health and Human Services; and providing premium and coverage information to the IRS.
Welfare benefit plans
If you offer your employees an employee benefit plan, it is important for you to determine whether or not the plan qualifies as an Employee Retirement Income Security Act (ERISA) welfare benefit plan. Prior to the enactment of ERISA, the regulation of welfare benefit plans was erratic. As a result, ERISA was enacted to protect the interests of welfare benefit plan participants. The plan will qualify as an ERISA welfare benefit plan if it is a plan, fund, or program that you establish or maintain for the purpose of providing your employees with benefits covering circumstances such as the following: sickness, accident, disability, or life insurance; unemployment benefits; vacation benefits; apprenticeship or other training programs; day-care centers; scholarship funds; prepaid legal services; or holiday and severance pay plans.
Tip: ERISA welfare benefit plans must conform to certain fiduciary, reporting, and disclosure requirements.
Tip: An ERISA welfare benefit plan must be in writing and must name one or more fiduciaries to control the plan's operation and administration. ERISA considers an individual to be a plan fiduciary if the individual exercises discretionary authority or control over plan management and assets, gives investment advice regarding the plan for a fee, or has discretionary authority over the plan's administration.
Welfare benefit plans that are exempt from ERISA
The following types of welfare benefit plans are exempt from ERISA: government plans, church plans, state-mandated plans, plans of the U.S. government that are primarily for the benefit of nonresident aliens, and plans that provide benefits only for a select group of management or highly compensated employees.
Benefits that are not ERISA welfare benefits
ERISA welfare benefit plans do not include benefits such as overtime pay, the maintenance of employee recreation and dining areas, the maintenance of first-aid facilities, and distribution of gifts by an employer to employees on holidays.
IRS tax treatment of ERISA welfare benefit plans
The IRS allows you to deduct a limited portion of the cost of a welfare benefit plan. Assuming that you use the cash method of accounting and have established a qualified asset account (the account that holds the funds set aside by the business to provide for the benefits), you can deduct the fund's qualified cost. To arrive at the qualified cost, you use the following method:
Qualified cost (the amount the business provides for benefits)
Qualified direct cost (the total cost, including administrative expenses, that the business would deduct for benefits provided during the tax year if the business had provided benefits directly to the employee)
Additions made to the qualified asset account for the year
Tip: If you pay more than the fund's qualified cost, you can carry the excess over to the next tax year.
Tip: The process by which you calculate your deduction is extremely complicated and requires an intimate understanding of IRS tax rules. This discussion is intended to provide you with only a general understanding of the subject matter. For more information, consult additional resources.
Welfare benefit funds
Welfare benefit funds are methods of funding an employee welfare benefit plan. A welfare benefit fund allows you to pre-fund a plan by making deposits into the fund and using those deposits to purchase the welfare benefits at a later date. There are two types of welfare benefit funds: the welfare benefit trust, also known as a taxable trust, and the voluntary employees' beneficiary association (VEBA) trust, also known as a nontaxable trust. VEBAs and welfare benefit trusts are organizations that you establish to hold funds to pay benefits under an employee benefit plan. While income from the VEBA can be tax exempt, income from a welfare benefit trust is taxable. In certain situations, the IRS allows you to deduct contributions you make to a VEBA or welfare benefit trust in the year the benefits are paid out to your employees.
A cafeteria plan allows employees to choose from an array of benefits and customize a benefits package that is based on their individual needs. Employees can purchase benefits from the plan by using either a flexible spending account or a dollar amount that you previously allocated to them. The IRS may allow you to deduct contributions that you make to a cafeteria plan, depending on the types of benefits you provide under the plan. Furthermore, cafeteria plan benefits are not includable in your employees' gross income as wages, reducing your taxable payroll. A reduction in your taxable payroll results in a decrease in your payment of Social Security, Medicare, and federal unemployment taxes.
Tip: The health-care reform laws passed in 2010 included a provision creating "SIMPLE cafeteria plans" for small businesses, effective for years beginning in 2011. Simple cafeteria plans are treated as meeting nondiscrimination requirements applicable to cafeteria plans if they meet certain minimum eligibility, participation and contribution requirements. This safe harbor also covers nondiscrimination requirements applicable to certain benefits offered under the cafeteria plan, including group term life insurance, coverage under a self-insured group health plan, and benefits under a dependent-care assistance program.
Methods of funding cafeteria plans
There are numerous ways to fund your cafeteria plan. A flexible spending account (discussion to follow) allows your employees to contribute pre-tax dollars to an account that may later be used to reimburse them for qualified expenses. A premium-only cafeteria plan allows you to pay for a certain amount of your employees' health coverage while your employees pay the remaining difference with pre-tax dollars through a salary reduction program. An add-on cafeteria plan provides basic low-level benefits to your employees and allows them to supplement or add to those benefits. Under an opt-up/opt-down cafeteria plan, you provide both high- and low-level benefits and allow your employees to either decrease or increase their level of benefits. A core plus option plan allows employees to supplement their benefits beyond the core benefits that you provide to them under the plan. Under a modular cafeteria plan, you combine certain benefits into packages and allow your employees to choose the benefit package that suits their particular needs. Under a full-flex cafeteria plan, you place a price on benefits and then give your employees a certain number of credits with which to purchase the benefits.
Flexible spending accounts
A flexible spending account (FSA) allows your employees to contribute pre-tax dollars to an account that may later be used to reimburse them for qualified expenses. Since contributions are made before taxes, employees save Social Security taxes, federal income tax, and, in most cases, state and local income taxes on the money they put into the account. Your employees' pre-tax contributions lower your gross payroll, resulting in a decrease in your matching payments of Social Security and Medicare taxes, as well as unemployment taxes. Employers can offer flexible spending accounts to help employees pay for qualified health and dependent care expenses. In 2019, the contribution limits are $2,700 for health care FSAs and $5,000 for dependent care FSAs.
Health reimbursement arrangements
A health reimbursement arrangement (HRA) is an arrangement that allows employees to pay for medical costs using a pool of employer-provided funds (employees cannot make contributions). The HRA reimburses employees for qualified medical expenses, up to a maximum amount per coverage period. Reimbursements received by employees are not taxable income. Employees may carry over unused funds from year to year.
Tip: Many employers who establish HRAs require high-deductible coverage to help fund the account.
Caution: HRAs can be used to pay for doctor's bills, prescription medicine, and certain other qualified medical expenses.
Health savings accounts
A health savings account (HSA) is a tax-favored vehicle where the funds are earmarked for medical expenses. An HSA must be combined with a high-deductible plan. Amounts contributed to the HSA belong to the employee and are completely portable, remaining with the employee if they switch jobs, become unemployed, or retire. Amounts left in the individual's account at his or her death may be bequeathed to a spouse or other beneficiary. Contributions made by employees may be either pre-tax if offered through a cafeteria plan or tax deductible (even if the employee does not itemize). Contributions you make are tax deductible in the year they are made as a business expense.
Caution: As of 2011, tax-free HSA dollars can no longer be used to purchase most over-the-counter items not prescribed by a doctor. Also effective January 1, 2011, the tax on HSA distributions that are not used for qualified medical expenses increased to 20% from 10%.
Although cash compensation is not traditionally thought of as an employee benefit, it plays a major role in your employee's overall benefits package. Most employee benefits are valued according to their cash equivalency, and many benefit plans have contribution schedules that are based on your employee's rate of pay. In addition, cash compensation appeals to many employers since it is easier to administer than traditional employee benefits. While the IRS reasonableness requirement applies to both the cash and noncash compensation in your employee's benefits package, it most frequently comes up when the IRS suspects the disguising of dividends, which are not deductible and must be included in your employees' gross income, as cash compensation. As a result, if the IRS sees a significant increase in an employee's cash compensation, you will have to show that the increase was reasonable. If the IRS denies a compensation deduction, it may recharacterize the payments as dividends.
Example(s): Acme Corp., a financially unstable company with 10 employees, pays $100,000 to an administrative assistant. Acme then treats the $100,000 as deductible compensation for tax purposes. The IRS will most likely determine that the $100,000 that Acme paid to the administrative assistant was not reasonable and therefore disallow the compensation deduction, treating it as a nondeductible dividend.
Caution: In addition to declaring that an employee's compensation is unreasonable, the IRS may issue negligence penalties for what it sees as excess deductions. The possibility of negligence penalties leads many corporations to enter into payback agreements with their employees. Payback agreements generally require an employee to pay back any excess cash compensation to the corporation if the IRS disallows a deduction for compensation. However, it is important to note that the IRS often sees these types of agreements as indicators that the company intended to reward the employee with unreasonable cash compensation.
Tip: Cash compensation benefits mainly arise in the context of regular or C corporations.
Tip: Certain publicly held corporations are subject to additional limitations for compensation in excess of $1 million.
Tip: For more information on IRS rules regarding cash compensation, see Section 162 of the Internal Revenue Code.
Tip: In general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Dividends are now taxed at a maximum rate of 20%. Because of the reduced tax rate for dividends, employees who are also shareholders may prefer dividends to wages, depending on their tax bracket. Dividends have the further advantage, for both the employee and the employer, of being free from payroll taxes.
Noncash benefits, also known as fringe benefits, can include the use of a company car, a country club membership, dependent care assistance, health insurance, and even tickets to sporting events. Unless the fringe benefit that you provide to your employee falls within certain exceptions, you must include the value of the fringe benefit in your employee's gross income as wages. You can determine the value of the fringe benefit by using either the general valuation rule or one of the special valuation rules. While you cannot deduct the value of the fringe benefits that you provide to your employees, you can deduct the costs of providing your employees with the fringe benefits as a trade or business expense.
General valuation rule and special valuation rules
General valuation rule
Under the general valuation rule, you must include in your employee's wages any amount over the fair market value (FMV) of a fringe benefit when it is more than:
- Any amount the employee paid for the benefit
- Any amount the law excludes from income
The FMV of a fringe benefit is the amount your employee would have to pay a third party to buy or lease the fringe benefit.
Tip: When you provide your employee with a company car, the FMV of the car is the amount your employee would have to pay a third party to lease the same or a similar car in the same or similar circumstances.
Special valuation rules
Special valuation rules include the annual lease value rule, the vehicle cents-per-mile rule, the commuting rule, and the employer-operated eating facility rule. You can use the special valuation rules only if one of the following conditions is met:
- You treat the value of the benefit as wages for reporting purposes by the due date of the return for the tax year that you provide the benefit
- Your employee includes the value of the benefit in income by the due date of the return for the year the employee receives the benefit
- Your employee is not a control employee
- You demonstrate a good faith effort to treat the benefit correctly for reporting purposes
Section 132 benefits
While you must include the value of most fringe benefits in your employee's gross income, there are certain noncash/fringe benefits that the IRS specifically allows you to exclude from your employee's wages. These fringe benefits are found in Section 132 of the Internal Revenue Code and include:
- No-additional-cost service
- Qualified employee discount
- Working condition fringe
- De minimis (minimal) fringe
- Qualified transportation fringe
- Qualified moving expense reimbursement
- Certain athletic facilities
Tip: Each of the Section 132 benefits is subject to its own rules and requirements. See Section 132 of the Internal Revenue Code for more information.
Caution: The exclusion is not allowed if another tax rule provides for the tax treatment of the fringe benefit (e.g., dependent care assistance and tuition reductions).
Tip: Certain nondiscrimination rules apply to no-additional-cost service and qualified employee discount fringe benefits.
No-additional-cost service is when you provide your employee with a service at no additional cost to yourself. No-additional-cost services are usually found in excess capacity services, such as airlines, trains, buses, and cruises.
For example, an airline allows its employees to fly free on those planes that have empty seats. The airline is providing a no-additional-cost fringe benefit to its employees. By allowing its employees to fly free of charge on planes with empty seats, the airline provides its employees with a service that they sell to the general public, at no additional cost to the airline. The no-additional-cost service you provide to your employee is not includable in his or her income if you do not incur any substantial costs to provide that service to your employee. Also, you can claim a tax deduction for the cost of providing the service to your employees.
Qualified employee discount
A qualified employee discount is when you give your employee a price reduction on the same goods or services that you offer to your customers.
Tip: The no-additional-cost service and qualified employee discount benefits that you provide to your employees must be for goods or services that you offer for sale to your customers in the ordinary course of the same line of business in which the employee who receives the goods or services performs substantial services.
Working condition fringe
Working condition fringe benefits include any property or service that you provide to your employee where if the employee paid for the property or service, he or she could deduct it as a business expense. You can claim a business deduction for the cost you incur providing the property or service. A working condition fringe benefit can include benefits such as a company car or educational assistance.
De minimis (minimal) fringe
A de minimis fringe benefit includes any property or service that you provide to an employee that has so small a value that it would be unreasonable or administratively impractical to account for it. De minimis fringe benefits include use of a secretary to type a personal letter, occasional personal use of a copying machine, and occasional tickets to entertainment events. You can deduct the cost of a de minimis fringe benefit if the benefit is ordinary and necessary to your business.
Example(s): Acme Corp. allows its employees to use the photocopy machine for personal use. Acme estimates that the photocopy machines are used for company business 90% of the time and that employees use the photocopy machines for personal use 10% of the time. Since the employees' personal use of the photocopy machines is minimal, it would qualify as a de minimis fringe benefit.
Qualified transportation benefits
Qualified transportation benefits for employees include transportation in a commuter vehicle, a transit pass, or qualified parking. Qualified transportation benefits are, within certain limits, excludable from your employees' gross income. The value of a qualified transportation benefit is based on the benefit's FMV.
Qualified moving expense reimbursement
Qualified moving expense reimbursements are amounts that you give to your employee, directly or indirectly, as a payment for, or a reimbursement of, expenses that would be deductible as moving expenses if your employee paid or incurred them. Deductible moving expenses include the moving of household goods and personal effects from the former home to the new home, and traveling from the former home to the new home.
Tip: There is no dollar limit on the exclusion for qualified moving expense reimbursements. However, the expenses must be reasonable and substantiated.
Athletic facilities include any on-premises gym or other facility that you provide to your employees. The exclusion does not apply if you make access to the athletic facility available to the general public.
This article was prepared by Broadridge.
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