Fringe Benefit Taxation for Owners and Employees

Tax Savings with Section 125, HRA, and HSA Plans

A fringe benefit is non-monetary compensation for work. Fringe benefits can be provided by the business to employees, independent contractors, partners, and even to the owners.

Some fringe benefits are taxable to the recipient, but many have tax advantages over monetary compensation. Fringe benefits can be tax-free or partly tax-free, or they can defer taxes. Some fringe benefits, such as for health insurance, can even be free of employment taxes. Some fringe benefits can also offer reduced costs even if they are taxable, by taking advantage of group rates, such as life insurance that has a benefit greater than $50,000.

Fringe benefit taxation also depends on the business entity providing them. Owners of a sole proprietorship or a pass-through entity, including 2% shareholders of S corporations, are not considered employees, so they can receive benefits, but they do not have the tax advantages that they may have for rank-and-file employees.

While tax advantaged fringe benefits can be offered by a sole proprietorship, partnership, limited liability company, or S corporation to its employees, a C corporation can offer several more benefits that have tax advantages that are not available to the other entities. Moreover, owners of a C corporation can receive the same benefits with the same tax advantages that can be offered to the rank-and-file employees. Fringe benefits include:

• financial and tax planning,
• disability insurance and payments,
• group life insurance,
• loans to shareholders,
• stock options,
• employee stock ownership plans,
• special commuter vehicles, which corporations provide for commuting transportation for its employees and only if the vehicle is used at least 80% of the time for commuting employees; and
• the operating costs for corporate owned entertainment facilities for the time that the facilities are used solely for business.

Taxable fringe benefits are reported on the employees’ Form W-2, Wage and Tax Statement, which is usually issued at the end of the calendar year. Although independent contractors who perform services for the business can also be paid with fringe benefits, it is not common practice. If they are compensated with taxable fringe benefits, then they will be reported on Form 1099-MISC, Miscellaneous Income. Partners may also receive taxable fringe benefits, which are reported on Schedule K-1 (Form 1065), Partner Share of Income, Deductions, Credits, etc. Tax-free fringe benefits are generally not reported.

One key advantage of compensating employees with fringe benefits is that the most common benefits are taxed at a lower rate than monetary compensation — some are not taxed at all. Otherwise, fringe benefit taxation applies unless they satisfy the following requirements, where the fringe benefit must:

• be specifically excluded from taxation by the tax code,
• be provided in writing, which is usually accomplished through an employee benefit plan, and
• have no definite term length, such as for a specific amount of time or if an employee reaches a certain age.

Sometimes only a certain amount is excluded, so any benefit with a greater value than the excludable amount is taxable. If the employee pays for the benefit, then the payment amount is specifically deductible against the taxable amount under the return of capital doctrine. Some benefits to owner-employees are limited to a percentage paid to rank-and-file employees. Owner-employees with respect to fringe benefits are those who own more than 5% of the business.

For those benefits that are specifically excluded from taxation by law, all are excluded from income taxes, but a few are also excluded from Social Security and Medicare (FICA) taxes, and some are also excluded from unemployment (FUTA) taxes if they are employees:

• Fringe benefits that are exempt from income, FICA, and FUTA taxes:
  • Accident and health benefits. However, there is no exemption for plans that favor key or highly compensated employees over others. Other exceptions:
    • Long-term care benefits that are provided through a flexible spending arrangement are not exempt from income taxes.
    • Payments made to 2%-shareholder-employees of S corporations are not exempt from income or FICA taxes.
  • Achievement awards, up to $1,600 for qualified plans — $400 otherwise. ¹
  • Athletic facilities — facilities must be located on property owned or leased by the employer and used only by employees, their spouses, and dependent children.
  • Commuting transportation benefits are exempt up to certain limits, unless the business uses a commuter vehicle to transport employees to and from work. Otherwise these monthly limits apply:
    • transit passes:
      • 2017: $255
      • 2018: $260
    • qualified parking:
      • fully taxable to sole proprietors, partners, LLC members, or more than 2% S corporation owners if it is their benefit
      • 2017: $255
      • 2018: $260
    • $20 for bicycle commuting reimbursement expenses. ¹
  • De minimis benefits, which are mostly benefits where the burden of recording the expense would be high compared to the benefit provided, such as snacks and drinks, and the occasional personal use of business equipment. However, cash or its equivalent, such as a gift card, must always be included in the employee’s income, regardless of how little the amount is, since recording the amount would not be problematic.
  • Employer-provided educational assistance, within annual limits of $5,250 per employee. No more than 5% of this benefit can be paid to owner-employees.
  • Dependent care assistance — up to $5000 ($2500 for a married employee filing separately). No more than 25% of this benefit can be paid to owner-employees, their spouses, or dependents. ²
  • Employee discounts of up to 20% of the regular price for services and, for products, up to the average gross-profit percentage of all products sold by the business. ²
  • Employee stock options. Under certain circumstances, employee stock options may be subject to all taxes, but if the rules are followed, then the employee only has to pay long-term capital gains tax, which is much lower than the taxes on employment, that becomes due when the stock that was acquired by exercising the option is finally sold.
  • Employer-provided cell phones, if they are not part of a compensation package but are issued to facilitate business for the employer.
  • Health savings accounts, exempt up to the HSA contribution limits.
  • Group term life insurance. However, only $50,000 of coverage is exempt from FICA taxes. ^{1, 2}
  • Lodging on the business premises, if it is furnished as a condition of employment and for the convenience of the employer. ¹
  • Meals if furnished on the business premises for the convenience of the employer. This usually means that employees do not have an option to eat elsewhere without spending a lot of time traveling to and from a restaurant. Although there are many tech companies in big cities that provide free meals to its employees, the IRS may challenge this: No Free Lunch for Companies as IRS Weighs Meal Tax Rules – Bloomberg.
  • Moving expense reimbursements if they were for expenses that would otherwise be deductible by the employee if he paid them. ¹
  • No-additional-cost-services, which can be provided to employees at no additional cost to the business, such as airline employees receiving free flights by sitting in seats that would otherwise be empty or allowing the free personal use of tax software for employees of a tax-preparation company. Generally, these services can be provided at no additional cost because the company has fixed costs that cannot be lowered whether the service is used or not. However, the service cannot be provided at the expense of paying customers. ²
  • Retirement planning services. ²
  • Tuition reduction is exempt if for undergraduate education, or for graduate education if the employee teaches or does research. ²
  • Working condition benefits.
• Fringe benefits that are exempt only from income taxes:
  • Adoption assistance. Sufficient notice of this benefit must be given to all employees and reimbursed adoption expenses must be substantiated. Furthermore, no more than 5% of all reimbursed adoption expenses paid by the business may be paid to a shareholder or 5% owner of the business. ^{1, 2}
• Footnotes:
  • 1: Exemption does not apply to 2% shareholder employees of an S corporation.
  • 2: No exemption for highly compensated employees when they are favored over other employees.

Group Term Life Insurance

Premiums paid on the first $50,000 of group term life insurance are excludable from employees’ gross income (§79), a benefit that does not extend to proprietors or partners. To satisfy the group requirement, the employer must offer it to most of the employees. This exclusion only applies to term insurance, not ordinary life insurance or other types of insurance that have a cash surrender value.

For premiums paid in excess of $50,000 coverage, the employee must include a certain amount for each $1,000 in coverage that exceeds $50,000, depending on IRS uniform premium tables for $1,000 of group term life insurance protection. ^§79(c)

Even if the employee must include some of the paid premium as income, the group term life insurance is generally better than what he can purchase on his own. If key employees are favored by the plan, then they will not be eligible for the exclusion, in which case, they must include in their gross income the greater of actual premiums paid by the employer or the amount calculated from the uniform premiums table. Other employees are still eligible for the exclusion.

Cafeteria Employee Benefit Plans

A cafeteria employee benefit plan, also known as Section 125 plans, which may include a flexible spending arrangement, is a written plan that allows employees to select among a choice of fringe benefits or cash. For instance, an employee with a family may prefer dependent care assistance or life insurance over other benefits. However, if the employee chooses cash, then the cash is taxable as income to the employee. Employees can be common law or statutory employees, or leased employees who worked at least 1 year full-time. Businesses with cafeteria plans must file Form 5500, Annual Return/Report of Employee Benefit Plan annually.

The tax advantages of a cafeteria plan are less for key employees if they are favored by the plan that was not covered by a collective bargaining agreement, including the following:

• 2% shareholders of an S corporation, where the employee owned at least 2% of the total stock or 2% of the voting power at any time during the tax year, in which case, they would be treated as partners in regard to fringe benefits;
• Employees who must include the fringe benefits from a cafeteria plan as taxable income:
  • Highly compensated employees or their spouses, including:
    • corporate officers,
    • a 5% shareholder, who owns at least 5% of the total stock or its voting power, or
    • any employee who is highly compensated.
  • Key employees who receive at least 25% of the total nontaxable fringe benefits provided to all employees include the following:
    • An officer of the corporation whose compensation is greater than $165,000.
    • A 5% owner of the business or a 1% owner whose annual pay is greater than $150,000.

A cafeteria plan cannot include any benefit that defers pay, except a qualified 401(k) plan or certain life insurance plans that are provided by educational institutions. Benefits that can be offered under a cafeteria plan include:

• accident and health benefits,
• adoption assistance,
• dependent care assistance,
• group term life insurance coverage, and
• health savings accounts.

Benefits that cannot be offered in a cafeteria plan include:

• Archer MSAs,
• athletic facilities,
• de minimis benefits,
• educational assistance,
• scholarships or fellowships,
• employee discounts,
• cell phones,
• lodging, even if on business premises,
• meals,
• moving expense reimbursements,
• no additional cost services,
• commuting benefits,
• tuition reduction, and
• working condition benefits.

Simple Cafeteria Plans

Small employers, defined as those with no more than 100 employees, can establish what is called a simple cafeteria plan that is presumed to meet nondiscriminatory requirements, obviating the complex testing rules that apply to regular plans. Once established, the cafeteria plan can continue to be used until the business has an average of at least 200 employees in a subsequent year. The plan must cover all employees who worked at least 1000 hours in the previous plan year, but not business owners, including sole proprietors, partners, LLC members, and 2% shareholder employees of S corporations. The plan can exclude:

• employees:
  • younger than 21 at the end of the plan year
  • with less than 1 year of service by the end of the plan year
  • covered by a collective bargaining agreement
• nonresident aliens whose income is earned outside of the United States

Employers are required to contribute to the simple cafeteria plan in one of 2 ways:

• a percentage equal to at least 2% of the employee’s compensation or
• the lesser of an amount equal to at least 6% of the employee’s compensation or twice the employee’s salary reduction contribution. The salary reduction contribution option can only be selected if the contribution rate of any key employee is no greater than any other employee.