Should Employee Benefits be Treated as Exempt or Taxable?

By Jane Searing, CPA

Note: This article, originally published on January 1, 2018, has been updated to include the latest developments regarding the Tax Cuts and Jobs Act. The new information will be in blue italics.

Certain transportation and, in some cases, onsite recreational facility benefits have been treated as tax exempt to employees, and tax deductible to employers prior to passing the Tax Cuts and Jobs Act of 2017.

However, beginning January 1, 2018, for the benefits listed below, employers must make an important business and economic choice. They must decide whether to treat the benefit as taxable compensation to employees, or continue to treat the benefit as a non-taxable benefit but receive no tax deduction for the expense of providing the benefit.

Benefit Changes as of 2018

Which benefits are losing status as deductible to the employer and non-taxable fringe benefits to the employee?

  • Qualified transportation and commuting fringe benefits associated under Internal Revenue Code section 132(f), including:
    • Any transit pass
    • Qualified parking
    • Transportation in a commuter highway transportation vehicle between the employee’s residence and workplace paid by the employer
  • Any on-premises athletic facility as defined in section 132(j)(4)(B), if the benefit is no longer tax deductible by the employer under Internal Revenue Code section 274(e).
  • The 50-percent deduction previously allowed for meals and entertainment for recreational, social purposes under section 274(n).

Note: the change in the tax law does not automatically result in these benefits being taxable to employees. Also, the deduction is not automatically lost by the employer.  Under Internal Revenue Code section 274(e)(4), if the recreational facility is primarily for the benefit of employees who own less than 10% of the company, a deduction is allowed. If a deduction for any of the above named benefits is not allowed, the employer must make a choice either to treat the benefits as taxable compensation to employees, a deductible payroll expense, or continue to treat the benefit as non-taxable fringe benefit to the employees, but no longer deduct the expense.

The net effect of the change is more than just the loss of value of the tax deduction on the benefits to the employer. The corporate tax rate was decreased from 35% to 21%, while individual tax rates shifted only slightly.

Also, newly taxable benefits should be assumed to be the last dollars taxed or benefits taxed at the highest rate to which the employee is subject. In addition, because now the benefit is taxable wages, although deductible to the employer if treated as taxable wages, both the employer and employee must pay employment taxes on the benefits at 7.65%, assuming the employee is not over the FICA limit.

What Should Employers Do?

Following is an illustration of the decision employers must make regarding 2018 payroll:

Facts: The value of the benefits is $100,000. The employer is a personal service corporation. The average employee is in the 25% marginal tax rate and employment taxes are 7.65% for both the employee and employer.

Option 1: The employer may continue to pay for the benefit and forgo the tax deduction, treating the benefit as a tax-free fringe benefit to the employee.

  • Cost to employer: $100,000 cash for benefits and $21,000 in additional taxes paid dues to loss of deduction = $121,000
  • Benefit to U.S. Treasury: $21,000
  • Benefit to employees: $100,000
  • Cost to employees: $0

Option 2: The employer can continue to pay for the benefit, treat the benefit as taxable wages, withhold the value of the benefit from the employees’ other wages, and pay the employer payroll taxes.

  • Cost to employer: $100,000 + 7,650 – $22,606 = $85,044 ($100K benefit + payroll tax less deduction for benefit and payroll taxes = net cost to employer)
  • Benefit to employees: $100,000
  • Cost to employees: $25,000 + $7,650 = $32,650
  • Net benefit to employee: $67,350 (Benefit net of tax liability)
  • Benefit to U.S. Treasury: $25,000 – $22,606 + 7,650 + 7,650 = 2,394 (employee income tax less employer tax deduction plus total payroll taxes)

Option 3: The employer can let the employee decide if they want to continue to receive the benefit and be taxed on the value of the benefit. The taxes and benefits would be a hybrid between Option 1 and 2, depending upon which employees take the benefit, and whether the employer treats the benefit as taxable or non-taxable wages.

The employee’s choice to forgo the deduction results in substantial cost to the employer. The employee receives the same benefit, but, depending upon the employee’s marginal tax rate, there is a tax cost to receiving the benefit.

The employer may be better off economically splitting the difference and grossing up the employees’ wages to cover all or part of the increased tax cost to be in the same position rather than lose the tax deduction during the tax law’s first year of implementation.

Questions?

Please contact Jane Searing if you have questions about how tax reform might affect your employee benefit plan, or visit our Tax Cuts and Jobs Act page for additional resources.

© Clark Nuber PS, 2018. All Rights Reserved

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