Offering employees superb benefits packages, in addition to competitive salaries, can bolster your recruitment process and help you attract and retain top talent. However, before you ramp up your employee benefits, you should understand how each benefit is taxed. Having a good understanding of what fringe benefits are and how each is taxed (or not taxed) can save you and your employees from unpleasant surprises during tax season.
How do taxes and fringe benefits work?
A fringe benefit, sometimes referred to as an employee benefit or perk, is the additional compensation or benefit an employer offers an employee on top of their regular salary or wages. The IRS considers most fringe benefits to be taxable compensation that must be reported on tax forms (e.g., Form W-2, Wage and Tax Statement and Form 1099-MISC, Miscellaneous Income).
“Fringe benefits that are considered taxable are equal to taxable income and therefore [are] taxed as regular income,” Jorge De La Nuez, senior vice president of payroll tax – HCM at Vensure Employer Services, told Business News Daily. “When you receive this type of taxable fringe benefit from your employer, taxes are deducted from your paycheck and reported on your annual tax return.”
FYI
FYI: To make sure you are paying your payroll taxes correctly, you must understand how payroll processing works. You should have a proper payroll system in place that can handle the calculation and payment of your payroll taxes for you.
What are taxable fringe benefits?
Employers can provide their employees with a variety of desirable benefits, but it is important to know which ones are subject to taxes (and must be reported) and which benefits are not. Unless otherwise stated by the Internal Revenue Code, an employee fringe benefit is likely taxable to some extent.
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Most fringe benefits come in the form of a product or service, as opposed to a cash payment, so they are taxed on their cash-value equivalent based on fair market value.
“This equivalent value is taxable, just like how cash compensation is taxable, except that the employee typically enjoys the benefit in the form of a product, service or reimbursem*nt,” said Moses Balian, enablement manager for human resources at Justworks.
These are some of the most common taxable fringe benefits, according to Balian:
- Discretionary bonuses (including gift cards)
- Income from the exercise of nonstatutory stock options
- Taxable income from the issuance or vesting of restricted stock
- Employer-provided cell phone (nonbusiness use)
- Gym memberships
- Employer-provided vehicle or car lease
- Transportation benefits in excess of employer/employee pretax deferrals under a Section 132 Plan
- Housing allowance
- Moving expenses
- Meals and lodging (distinct from business travel)
- Reimbursem*nt for classes or development unrelated to work (e.g., foreign language classes, if those classes are not work-related)
- Travel expenses not related to business (e.g., an extension to a business trip)
- Group term life insurance (greater than $50,000 of coverage)
In some circ*mstances, some of these benefits may be nontaxable. For example, De La Nuez said that additional fringe benefits, such as reimbursem*nts, are not taxable at the time of payment to the employee, as they have been paid with post-tax earnings. This can include reimbursem*nts for gym memberships, tuition and internet connectivity.
As you offer a wider variety of benefits to your employees, it is important to keep accurate tabs on your taxation and reporting obligations. Balian recommended finding a payroll service that can help you stay compliant.
“Your payroll platform needs to be sophisticated and straightforward enough to process and appropriately categorize your fringe benefits so as to avoid tax mistakes and potential penalties,” Balian said.
Key Takeaway
You are likely best served by finding an accountant who can help you identify which of your fringe benefits are taxable.
What are nontaxable fringe benefits?
Although most fringe benefits are subject to taxation, certain benefits are considered nontaxable. In most instances, nontaxable fringe benefits are not subject to federal income tax withholding, Social Security, Medicare or federal unemployment tax, and they often do not have to be reported on a W-2. However, it is important to know the IRS conditions upon which these benefits are deemed nontaxable, as they can vary on a case-by-case basis.
“Fringe benefits that are considered nontaxable by the IRS are deducted on a pretax basis and [are] usually reported on your annual tax return,” De La Nuez said. “While these fringe benefits may be deducted on a pretax basis, certain contributions made to them may be taxable upon withdrawal.”
These are some of the most common nontaxable fringe benefits:
- Achievement awards (up to $1,600 for qualified plan awards)
- Adoption assistance
- Disability insurance (including employer-paid disability insurance premiums; most benefits an employee receives under the policy are taxable)
- Dependent care assistance (up to $5,000 per year, as long as it doesn’t exceed the earned income of the employee or employee’s spouse)
- Educational assistance (up to $5,250 annually)
- Employee stock options (may be subject to taxes)
- Group term life insurance (coverage shouldn’t exceed $50,000)
- Health savings accounts
- Medical insurance plans (e.g., health, dental and vision care)
- On-premises athletic facilities
- Lodging and meals (if offered on business premises or as a de minimis fringe benefit)
- Retirement planning services (some benefits may be tax-deferred)
- Qualified employee discounts (up to certain limits; employee discounts differ from subsidized memberships)
- Qualified transportation benefits, also known as commuter benefits (up to certain limits)
- No-additional-cost services
Employers can also take advantage of an affordable, nontaxable fringe benefit option called de minimis benefits, which are benefits with a value so minute that the IRS deems it unreasonable or administratively impractical to account for them.
De La Nuez said common fringe benefits that fall into this category may include office snacks or drinks, group meals, birthday or holiday gifts (not cash), employer-provided local transportation, personal use of a business cell phone, and theater or sporting event tickets. [Read related article: Workplace Incentives That Your Employees Want]
“Using these types of fringe benefits go a long way for attracting and retaining top talent while not creating an accounting or administrative burden on the business,” De La Nuez said.
FYI
It's important to remember that benefits for self-employed entrepreneurs can also be taxable. If you are self-employed, be sure you know which benefits are taxable.
How can you determine taxable vs. nontaxable benefits?
When you create an employee benefits package, it can help to identify each benefit’s taxability and to clearly outline your offerings in your employee handbook. It is often helpful to work with an experienced benefits administrator to create your benefits package. This is especially true for work-related professional-development and tuition-reimbursem*nt plans.
“These [plans] come with strict rules, such as having a plan document, not being offered as a choice versus other forms of compensation, and they must not discriminate in favor of highly compensated employees,” Balian said. “Be sure to work with a reputable Section 127 Plan administrator before issuing nontaxable tuition assistance reimbursem*nt to employees.”
According to Balian, many growing businesses make mistakes when paying taxes on these two types of fringe benefits in particular. Work-related professional development can be reimbursed through a nontaxable expense reimbursem*nt; however, tuition reimbursem*nt for graduate- and undergraduate-level courses is nontaxable up to $5,250 per year, and only under a formally established Section 127 Plan. This is why it’s necessary to have a formal plan document that spells out who is eligible for educational assistance and exactly what is covered. Tuition reimbursem*nt expenses over $5,250 are taxable. [Read related article: Should You Outsource HR?]
Paying the right taxes, on the right benefits
Not paying taxes on certain fringe benefits can raise compliance issues and lead to fines, but you could also be paying taxes when not necessary. Knowing whether you’re overpaying comes down to setting up a top-notch payroll system and working with a tax professional. This way, your tax calculations and payments will be automatic, and an expert will ensure you’re doing everything right. Fringe-benefit taxation may seem confusing at first, but you have ample resources for paying what you owe — and not a penny more.
Max Freedman contributed to this article. Source interviews were conducted for a previous version of this article.
