By Jane Searing, CPA and Steve Shulze
Note: This article has been substantially updated since its original publication date, please refer to the latest article here.
Employee benefits that were formerly tax-free benefits under IRC 132(f) (transportation, parking, and on-site exercise facilities) are now only tax free if:
- The employer is a for-profit business and forgoes the federal income tax deduction, or
- The employer is a tax-exempt organization and pays unrelated business income tax on the value of those benefits.
Otherwise, those benefits are now taxable wages to the employee.
This change to the tax law is straightforward. The tax consequence to the employee depends upon the employer’s decision. Simple, right?
Unfortunately, nothing in tax, and especially employment tax, is ever as simple as it seems on first blush.
How Are the Benefits Funded?
There are three possible ways these benefits are funded. Two are simple, but the third likely needs Treasury guidance. This is because the third option’s outcome depends upon who is paying for the benefit and whether the employee can “reasonably treat the benefit as non-taxable benefit under IRC section 132(f).”
Funding Option #1: 100% Employer-Paid Benefits
If the employer pays for the benefit and takes a deduction for the value of the benefit, the employer and the employee will both pay payroll tax on the value of the benefit, and the employee will pay income tax on the value of the benefit.
In this funding option, the employer receives a federal tax deduction for both the benefit and payroll taxes they have paid. The employee still receives the benefit, they now receive the benefit as an after-tax benefit.
If the employer is a tax-exempt entity, the employer avoids paying unrelated business income tax on the value of the benefit if the employer treats the benefit as a taxable benefit to the employee.
Alternatively, the for-profit employer may decide not to take a tax deduction for the value of the benefit. If the employer does not take a deduction for the benefit, then the employee may treat the benefit as a non-taxable fringe benefit under IRC section 132(f). Because the benefit is a non-taxable fringe benefit, neither the employer nor employee pays payroll taxes on the benefit.
If the employer is a tax-exempt entity, and does not treat the benefit as taxable income to the employee, the employer must pay unrelated business income tax on the value of the benefit.
Funding Option #2: 100% Employee-Paid Benefits
If the employer is not paying for the benefit, they can make the IRC section 132(f) benefits available to the employees by allowing employees under IRC section 3401(a)(19) to pay for benefits with pre-tax dollars. This IRC section states employees may use pre-tax dollars to pay for benefits if they have a reasonable belief the benefit would be a non-taxable fringe benefit.
Because the employer is not paying for the benefits, there is no evidence to suggest the employer would not have treated the benefit as a non-taxable fringe benefit.
It would therefore seem reasonable to allow employees to continue paying for transit passes and parking benefits offered under 132(f), with pre-tax payroll withholding.
Funding Option #3 – Employee and Employer Co-Paid Benefits
When the employee and employer split the cost of the benefit, it is not clear IRC section 3401(a)(19) will allow for payment of the employee portion with pre-tax dollars.
With a plain-face reading of Code section 3401(a)(19), it would seem there’s only one way an employee could have a reasonable belief the employee’s half of the benefit was a non-taxable fringe benefit. This would only occur if the employer opted to forego the federal tax deduction, or paid unrelated business income tax on the value of the benefit, for the employer paid portion. Otherwise, the employee has no reason to believe the employee’s portion is a non-taxable fringe benefit under 132(f).
However, because the employer is not paying the employee’s portion, there is a colorable argument the employee’s portion should be exempt. It is a transportation benefit covered under 132(f) paid for by the employee and the employer has no deduction available nor unrelated business income tax obligation on that portion. Therefore, the employee should be allowed to use pre-tax dollars.
What Can Treasury Do?
Treasury can solve this ambiguity by issuing guidance stating employees may pay for their portion of any bifurcated benefits with pre-tax dollars, which would be otherwise covered under 132(f)—regardless of the employer’s decision to treat as a non-taxable fringe benefit.
This would be a reasonable approach, as the employer does not have the option to take a deduction on the portion of the payment made by the employee. The employee should be allowed to treat the portion paid for by the employee as a tax-free employee benefit under IRC section 132(f).
If you would like assistance discerning how the change in the tax law may affect your organization, your employers, or your employees, please contact your Clark Nuber tax advisor.
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