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 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:

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 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:

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.

MAGI Restrictions on the Adoption Credit by Year
Year Maximum
2024 $16,810 $252,150 $292,150
2023 $15,950 $239,230 $279,230
2022 $14,890 $223,410 $263,410
2021 $14,440 $216,660 $256,660
2020 $14,300 $214,520 $254,520

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:

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:

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 provided by educational institutions. Benefits offerable under a cafeteria plan include:

Benefits not offerable under 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:

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:

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.