Taxation of Fringe Benefits

2023-11-30A 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 with a benefit exceeding $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 with tax advantages unavailable 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:

• health insurance
• disability insurance and payments
• group life insurance
• financial and tax planning
• 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 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:

• 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 exceeding 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 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:

• Fringe benefits 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 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 of tangible personal property that is deductible by the employer, but only up to $1,600 for qualified plans — $400 otherwise. If the employer's deduction is less than the cost of the property, then the employee is taxed on the greater of the difference between the cost of the property and the deduction, but no more than its fair market value, or the FMV minus the deduction. Safety achievement awards are tax-free to rank-and-file employees only if no more than 10% of the employees receive such awards per year; however, such awards are taxable if the employee is a manager, administrator, or a clerical or professional employee. Awards for length-of-service are only tax-free if not given within 5 years of the start of employment or if the employee did not receive such an award within the previous 5 years. 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. From 2015 onward, the exemption for transit passes and qualified parking have been permanently equalized. For independent contractors, partners, and 2% shareholders of S corporations, only up to $21 per month of transit passes is tax free as a de minimis benefit; if the value exceeds $21, then the entire amount is taxable. Monthly limits by year:
    • commuter highway vehicles and transit passes:
      • 2024: $315
      • 2023: $300
      • 2022: $280
      • 2020 - 2021: $270
• 2019: $265
• 2018: $260
• 2016 - 2017: $255
• 2015: $250, Congress nearly doubled this break in January, 2016
• 2014: $130, changes in the tax law have greatly reduced this benefit from prior years.
• 2013: $245
• 2012: $240
• qualified parking:
  • fully taxable to sole proprietors, partners, LLC members, or more than 2% S corporation owners if it is their benefit
  • 2024: $315
  • 2023: $300
  • 2022: $280
  • 2020 - 2021: $270
  • 2019: $265
  • 2018: $260
  • 2016 - 2017: $255
  • 2015: $250
  • 2014: $250
  • 2013: $245
  • 2012: $240
• $20 for bicycle commuting reimbursement expenses, but only if the bicycle is used for all the commute. Commuting to a train station, for instance, does not qualify. However, this cannot be claimed if the employee also receives qualified parking or transit passes. ¹
• From 2018 through 2025, under the Tax Cuts and Jobs Act, passed by the Republicans at the end of 2017,  bicycle commmuting reimbursements can still be deducted by the employer, but must be included in the employee's income. Employer expenses for qualified transportation and parking benefits will no longer be deductible by the employer. However, employees will be able to exclude qualified transportation fringe benefits from income.
• 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 — employer-provided daycare services provided under a nondiscriminatory plan is tax-free up to the lesser of the earnings of the lower income spouse or $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
  • If a spouse is a full-time student or is disabled, then, for calculating the limit of this tax-free dependent care assistance, that spouse is presumed to earn $250 per month for 1 dependent, or $500 per month for 2 or more dependents. The limit for the tax-free exclusion is figured on Form 2441, Child and Dependent Care Expenses.
  • Expenses for dependent care are also excludable from income if they would also qualify for the dependent care credit.
  • Any reimbursement of expenses by the employer is also excludable from income, but only if the care provider is not a dependent of either spouse or by their child younger than 19. The employer must be given the care provider's name, address, and tax identification number, and that identifying information must also be listed on the taxpayer's return when claiming the exclusion.
• 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 must pay only the 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 retirement advice, but only if the employer maintains a qualified retirement plan. However, the retirement advice can cover general retirement options, not just information about the employer's retirement plan. Retirement services, such as for accounting, legal, brokerage, or tax preparation services are not included.
• 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. Utilities, such as gas, electric, sewer, and water, are also tax-free if the lodging also qualifies as a tax-free benefit, but the employee may not deduct utility payments if he pays them. 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. The meals must be eaten right before, during, or right after the work shift; otherwise, their value is taxable. 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.
  • Meals and lodging are not tax-free if the employee has the choice of a cash allowance instead, even if she chooses the meals or lodging.
• Moving expense reimbursements if they were for expenses that would otherwise be deductible by the employee if he had 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. Highly compensated employees may also receive these services tax-free only if they are also available to the other employees. ²
• Retirement planning services. ²
• Tuition reduction is exempt for undergraduate education if the reduction was not as payment for services, or for graduate education; if the graduate teaches or does research, then the tuition reduction will be tax-free only if the graduate also receives regular pay for her services. The graduate student exclusion is for teaching and research assistants only — not faculty or other staff members, or their spouses or dependents. Faculty and other staff members can, however, receive tuition reduction as a tax-free working condition fringe benefit. ²
• Working condition fringe benefits are benefits that would be deductible by the employee if the employee had paid for them:
  • The business use of company cars and planes can be provided as a tax-free working condition fringe benefit. The value of any personal use is taxable, which is figured from IRS tables. A log should also be kept to substantiate business use. Because personal use is presumed to be limited for some types of vehicles, logs do not have to be maintained for vehicles obviously designed or marked for business, such as ambulances, tractors, garbage trucks, and other such vehicles.
  • Chauffeur services are tax-free for business use, but not for personal use. If a bodyguard is also provided for business security, then both the bodyguard and chauffeur services are completely tax-free if the automobile is designed for security and the bodyguard is trained in evasive driving techniques and is part of a 24-hour security program, although the value of commuting and other personal travel is still taxable.
  • The employer must withhold payroll taxes from taxable automobile benefits, but has the option of withholding income taxes. If the employer does not withhold income taxes, then the employee must be notified thereof, to consider whether estimated tax payments must be made. If the employer includes the entire lease value of the vehicle on Form W-2, then the employee must deduct the business use on Form 2106, Employee Business Expenses. Previous to the 2017 Tax Cuts and Jobs Act (TCJA), this deduction + any unreimbursed operating expenses can only be claimed as a miscellaneous itemized deduction subject to the 2% of AGI floor, but the TCJA eliminated this deduction.
  • Employer-provided cell phones, if they are not part of a compensation package but are issued to facilitate business for the employer.
  • Employer-paid subscriptions to business-related publications or memberships to professional organizations related to the employer's business.
  • Employer-provided job-placement assistance is tax-free for finding jobs for employees in the same line of business as the employer and if the employee does not have the option of receiving cash instead. Interviewing skills instructions and resume preparation, and for executives, secretarial support and the use of a private office can also be provided as a tax-free benefit. If severance pay is offered as an alternative, or in addition to, job-placement assistance, then the employee is taxed on the difference between the severance pay and the value of the job-placement assistance.
• Fringe benefits 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.

Employer-Provided Adoption Assistance

An employer can provide tax-free adoption assistance to its employees, up to an inflation-adjusted limit per adopted child. This income exclusion for employer-provided adoption assistance is subject to the same limit and modified adjusted gross income (MAGI) restrictions as the adoption credit. However, for a child who is not a US citizen or resident, any employer assistance must be reported as wages until the year in which the adoption is finalized, then the income exclusion can be claimed on Form 8839, Qualified Adoption Expenses. The amount of income that can be excluded is also limited by MAGI, where the maximum exclusion amount is reduced if  the MAGI is between the income phaseout threshold and the income limit; if the MAGI is higher, then no income can be excluded. The adoption assistance limits are adjusted annually for inflation.

The employer-provided assistance must be pursuant to a nondiscriminating plan. The child must be younger than 18 or physically or mentally incapable of self-care. Employer payments for adoption assistance will be reported on Form W-2, including any pretax salary reduction contributions made by the taxpayer to a cafeteria plan to cover adoption expenses. However, the employer's adoption assistance + certain other tax-free foreign income are included when figuring the applicable MAGI restrictions.

A married employee must claim the income exclusion on a joint return, unless legally separated or if the employee lived apart from his spouse for the last 6 months of the year, in which case, the exclusion can be claimed on a separate return.

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. However, there is no limit if the beneficiary is a tax-exempt charitable organization or the employer. There is also no limit for retirees, if they retired because of a total and permanent disability and remain covered by the company's plan. Group term life insurance for a spouse or dependents is tax-free as a de minimis fringe benefit if the policy is $2000 or less; the cost of any excess amounts minus any amount paid by the employee is taxable.

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 with a cash surrender value. The portion of the premium paid by the employer for cash value policies is reported as wages on Form W-2, but not any portion paid by the employeeif the employee pays part of the premium, then  is reduced by that amount.

The $50,000 limit applies per employee, so if the employee works more than one job and receives group term life insurance from each, then the total amount of life insurance for that taxpayer that exceeds $50,000 will be taxable. 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. Key employees include:

• more than 5% owners
• more than 1% owners earning more than $150,000, and
• company officers earning more than $170,000.

Split-Dollar Insurance Arrangements

An employer may offer additional life insurance through a split-dollar insurance plan, where the employer buys a permanent cash value life insurance on the life of the employee, paying part or all the annual premium. When the employee dies, the employer receives part of the proceeds, equal to the premiums paid, and the beneficiary designated by the employee receives the rest. An equity split-dollar insurance may also be offered that gives the employee the right to the cash surrender value that exceeds the premiums paid by the employer.

However, split-dollar insurance is taxed under 26 CFR 1.61-22 - Taxation of split-dollar life insurance arrangements, depending on whether the employer or the employee owns the policy. If owned by the employer, then the employee is taxed on the value of the life insurance protection, the amount of the cash value available to the employee, and on the value of any other economic benefit from the policy. If owned by the employee, then the premium payments by the employer will be treated as a loan to the employee, for which the employee will be taxed on the imputed interest. Additionally, some split-dollar insurance plans may be subject under IRC §409A for nonqualified deferred compensation plans. IRS Notice 2007-34, Guidance Regarding the Application of Section 409A to Split-Dollar Life Insurance Arrangements explains how split-dollar insurance plans may be classified as deferred compensation. Split-dollar insurance arrangements will not be treated as deferred compensation, if it only provides a death benefit or if the benefit is includable in income, called a short-term deferral under 26 CFR 1.409A-1(b)(4).

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 owning at least 5% of the total stock or its voting power, or
    • any employee earning at least the inflation-adjusted statutory minimum income for highly compensated employees.
  • 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 at least the inflation-adjusted statutory minimum income for key employees.
    • A 5% owner of the business or a 1% owner whose annual pay exceeds $150,000.

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

• highly compensated employee [§414(q)]:
  • 2024: $155,000
  • 2023: $150,000
• key employee [§416(i)(1)]:
  • 2024: $220,000
  • 2023: $215,000

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

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

Benefits not offerable under 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.

Dependent Care Flexibility Spending Arrangement

Employers may also offer a dependent care flexible spending arrangement, allowing the employee to contribute pretax earnings of up to the lesser of $5000 or the earnings of the lower income spouse. The employer may also allow a 2½-month grace period for unused dependent care FSA contributions.

The rules for the dependent care FSA are like the rules governing the dependent care fringe benefit:

• FSA distributions reduce the expenses eligible for the dependent care credit.
• Both spouses must be working, unless a spouse is disabled or a full-time student.
• Highly compensated employees may have a lower contribution ceiling, as required by nondiscrimination rules.

The amount of the reimbursement that is tax-free is calculated in Part III of Form 2441, Child and Dependent Care Expenses. The employer may limit reimbursements to the account balance, so if $1500 is paid to a daycare center, but there is only $500 in the account and the employee is contributing $500 per month, then the employer may pay 3 installments of $500 as money is added to the account.