The Tax Ins and Outs of Employee Fringe Benefits
So-called “fringe” benefits can actually be a significant component of compensation and a tool for attracting, motivating and retaining talented employees. But the tax treatment of fringe benefits is complex and often misunderstood. To avoid unpleasant tax surprises, it is important for employers and employees alike to familiarize themselves with the rules. This article discusses the tax treatment of benefits for owner-employers, depending on their company’s business structure, and warns to look out for family attribution rules.
Many taxpayers associate the term “fringe benefits” with minor forms of compensation, such as employee achievement awards or holiday gifts. But they also include more substantial benefits, such as health insurance and dependent care assistance. Taken together, fringe benefits can be a significant component of compensation and a tool for attracting, motivating and retaining talented employees.
But the tax treatment of fringe benefits is complex and often misunderstood. To avoid unpleasant tax surprises, it is important for employers and employees alike to familiarize themselves with the rules.
Exceptions that Prove the Rule
The IRS defines “fringe benefit” as “a form of pay for the performance of services.” This broad definition encompasses many forms of compensation that are subject to a wide variety of rules, restrictions and limits.
Despite this complexity, you can avoid tax mistakes so long as you remember one important rule: A fringe benefit is considered taxable compensation to an employee — subject to income and payroll taxes — unless the tax code or regulations say otherwise.
Fortunately for employers and employees, a number of fringe benefits are fully or partially excluded from an employee’s income, yet still deductible by the employer as a business expense. (For a list of common benefits treated this way, see the Sidebar, “Tax-Free Fringe Benefits.”)
Rules for Owner-Employees
C corporation stockholders who are also employees generally are entitled to the same tax-free fringe benefits as other employees. But owner-employees of pass-through entities — such as S corporations, partnerships and limited liability companies (LLCs) — are treated differently. Special rules apply to S corporation shareholders who own more than 2% of the company’s stock (or “2% shareholders”), partners, and members of LLCs taxed as partnerships. Usually, these owners are subject to tax on the following fringe benefits:
- Accident and health benefits;
- Group term life insurance;
- Contributions to Health Savings Accounts and cafeteria plans;
- Employee achievement awards;
- Meals and lodging furnished for the employer’s convenience;
- Qualified transportation benefits;
- Adoption assistance; and
- Moving expense reimbursements.
For other fringe benefits that are typically tax-free to employees, there is generally equivalent treatment for 2% shareholders, partners and LLC members. That is, fringe benefits are deductible by the employer and tax-free to the owner-employee.
What about sole proprietors? For the most part, they are not treated as employees for fringe benefit purposes, although they may be entitled to tax deductions for many expenses.
Watch Out for Family Attribution Rules
When determining whether an S corporation owner is a 2% shareholder, it is important to consider the family attribution rules. Under those rules, an individual is treated as the owner of stock held by his or her spouse, children, grandchildren and parents.
Suppose that a few years ago Adam owned 100% of the stock of an S corporation. In connection with his succession and estate plans, he transferred 99% of the stock to his daughter, Anna, and made her president of the company. Adam continues to work in the business and is covered by the company’s health insurance plan, which pays his $1,000 per month premium.
Under the family attribution rules, Adam is deemed to own 100% of the company’s stock (his 1% plus Anna’s 99%) for purposes of the 2% rule. As a result, $12,000 in annual health insurance premiums is included in his taxable income (although he may be entitled to a self-employed health insurance deduction for income tax purposes).
The tax treatment of fringe benefits is complicated. In addition to the rules discussed here, these benefits are subject to other rules and restrictions that vary depending on the specific benefit.
For example, some benefits (such as health insurance) are taxable to pass-through owners for income tax purposes but not for payroll tax purposes. And some benefits must be provided on a nondiscriminatory basis — that is, without favoring highly compensated employees. Also, tax regulations provide detailed guidance on the valuation of certain benefits for tax purposes.
If you have any doubt about how to treat fringe benefits for tax purposes, consult with Rob Swenson at [email protected] or call him at 312.670.7444.
This issue’s “Tax Tips” notes that, following the Supreme Court’s ruling on the Defense of Marriage Act, employers that previously paid FICA taxes on employer-paid health care coverage and certain other benefits for employees’ same-sex spouses may be entitled to a refund. It points out that, considering today’s higher federal gift and estate tax exemption, an estate plan with an outdated formula clause can create unexpected state tax liability. In addition, it warns that internships should benefit the intern more than the company.
Is Your Business Entitled to a Post-DOMA Tax Refund?
After the U.S. Supreme Court struck down as unconstitutional the Defense of Marriage Act’s (DOMA’s) definition of “marriage” for federal benefits purposes in June 2013, the IRS issued guidance clarifying that same-sex marriages are now recognized for federal tax purposes. Employers that previously paid FICA taxes on employer-paid health care coverage and certain other benefits for employees’ same-sex spouses may be entitled to a refund. For 2013 or earlier years, you may claim a refund anytime before the statute of limitations expires by filing one “Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund” (Form 941-X) for the fourth quarter of the year.
Do Not Overlook State Estate Taxes
The exemption for federal gift and estate taxes is more than $5 million, so federal estate taxes may be less of a concern. But state taxes can create a trap, particularly if your estate plan contains an outdated formula clause.
Say your plan includes a ten-year-old formula clause calling for an amount up to the current federal exemption to go into a credit shelter trust, with the balance going to your spouse (shielded from estate tax by the marital deduction). This strategy worked well when states simply adopted the federal exemption. But what if your state’s exemption is only $1 million today, with a 10% tax on the excess?
With a $5 million estate, the formula clause would funnel that amount into a credit shelter trust, triggering a $400,000 state tax liability [($5 million – $1 million) × 10%]. The state tax can be avoided by updating the plan to provide for $1 million to go into the credit shelter trust and the balance to your spouse. In some states there is another alternative that will allow you to choose the larger amount for federal purposes and the lower amount for state purposes.
Watch Out for Unpaid Interns
If your business uses unpaid (or underpaid) interns, make sure they are not really employees under federal law. Otherwise, you may be liable for back pay, overtime, payroll taxes and penalties.
Internships should benefit the intern more than the company. To protect yourself from liability, offer interns training they cannot get elsewhere and that is different from training you provide employees. Have interns acknowledge in writing their understanding that participating in the program does not guarantee them a job, and do not give them routine work.
If you have questions about this Tax Tip article, please contact Rob Swenson at [email protected] or call him at 312.670.7444.