Taxation of Fringe Benefits

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.

The taxation of fringe benefits 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:

Taxable fringe benefits are reported on the employees' Form W-2, Wage and Tax Statement, which is usually issued by January after the tax 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 benefits are taxable unless they satisfy the following requirements, where the fringe benefit must:

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 the beneficiaries are 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:

Highly compensated and key employees are defined as employees with at least the following inflation-adjusted minimum incomes:

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:

Benefits that cannot be offered in a cafeteria plan include:

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:

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