More Clarity on Taxable and Tax-Free Employee Benefits Under Tax Reform

Note: This article, originally published on January 12, 2018, has been updated to include the latest developments regarding the Tax Cuts and Jobs Act.

Among many other things, the Tax Cuts and Jobs Act affected how the government will tax certain employee benefits. Changes were made simultaneously to whether employers could take a deduction for certain benefits and whether employees could exclude certain benefits from income.

The intersections of these multiple changes (and the compounding factor of a whole new category of unrelated business income to tax-exempt employers) led to unprecedented confusion. Treasury has spent the better part of 2018 issuing guidance in the form of Publications, Notices, and answering questions in public forums on the updates.

When the law changed at the end of 2017, disallowing the deduction by employers paying for qualified transportation benefits employees could exclude from income, it was thought employers had a choice in how they could treat the benefits; taxable or non-taxable transportation benefits.

It was originally thought employee benefits, which are tax-free benefits under IRC 132(f) (transportation, parking, and on-site exercise facilities), would only continue to be tax free if:

1. The employer is a for-profit business and chose to forgo the federal income tax deduction, or
2. The employer is a tax-exempt organization and chose to pay unrelated business income tax on the value of those benefits.

As we now know, this is not how the law is being implemented.

Instead, the law starts with the question of whether the employee receives benefits defined in IRC section 132(f) or (j)(4) – qualified transportation benefits valued at up to $260/month or on-site athletic facilities which are restricted to highly compensated employees. It is a binary question. If the employee receives qualifying benefits, the employer must follow the tax treatment provided in the law. The decision point is whether the employer provides qualified benefits.

What are the tax outcomes of the three most common scenarios?

There are three ways these benefits are most commonly offered. The first is straightforward. The second required Treasury guidance, which they provided in Publication 15B. The last is likely a prospective change for most organizations.

Option #1: 100% Employer-Provided Benefits

If the employer pays for qualified transportation benefits within the non-taxable limits, the employee will not recognize taxable income on these benefits – up to $260/month. This is a non-deductible expense to the taxable employer. In the case of the tax-exempt employer, the cost of the benefits paid or incurred is converted to unrelated business income.

Option #2: 100% Employee-Paid Benefits

If the employer is not paying for the benefit, they can make the qualified transportation benefits available to employees by allowing them to pay for benefits with pre-tax dollars. Under IRC section 3401(a)(19), 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.

Publication 15B states the employer may not deduct the salary expense if the employee uses salary to purchase qualified transportation benefits through a qualified salary reduction plan. This means the tax treatment to the employer is the same — whether they pay the benefits directly or through a salary reduction plan, there is a loss of deduction. The difference is the out-of-pocket expense is greater when the employer pays for the benefit in addition to paying the employees’ compensation.

Funding Option #3: Get out of the “parking business”  

Because the critical factor is whether the employer provides qualified transportation benefits, the only way to avoid the loss of deduction is for the employer to not provide these benefits. This leaves employers with the only option of grossing up employees’ salary for an approximately equivalent amount and NOT requiring the compensation be used for qualified transportation benefits. For the compensation to be taxable to the employees and deductible to the employer, the employees must be free to use the additional compensation for any purpose

What guidance is still required from Treasury? 

The way the law was revised, employees exclude the fair market value of the qualified transportation benefits, which includes transit benefits and parking benefits each up to $260/month. The lost deduction is based on the cost paid or incurred by the employer. When the employer is paying an outside vendor for these benefits, there is usually a direct correlation between fair market value to the employee and cost to the employer. However, when the benefit provided is parking and the employer is not purchasing parking individual parking stalls, the cost is not always easily determined.

Treasury must still provide guidance for determining the cost of parking benefits when there are complicating factors such as the employer owns the parking lot, and everyone (the public, clients, employees) can park there for free. In the meantime, employers must arrive at a reasonable tax filing position, document the filing position based upon existing authority, pay taxes, and file returns based upon those reasonable best efforts at compliance with existing statutory authority.

Questions?

If you would like assistance discerning how the change in the tax law may affect your organization, your employers, or your employees, please contact Clark Nuber.

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