Learn the differences between taxable and nontaxable fringe benefits and how to create a great benefits plan for your company.
- Taxable fringe benefits are reported similar to how standard employee wages are reported.
- Bonuses, company-provided vehicles, and group term life insurance (with coverage that exceeds $50,000) are considered taxable fringe benefits.
- Nontaxable fringe benefits can include adoption assistance, on-premises meals and athletic facilities, disability insurance, health insurance, and educational assistance.
- This article is for small business owners and HR managers who need to know the difference between taxable and nontaxable fringe benefits as they create a benefits package for employees.
Offering employees superb benefits packages, in addition to competitive salaries, can bolster your recruitment process and help you attract and retain top talent. However, before you ramp up your employee benefits, you should understand how each benefit is taxed. Having a good understanding of what fringe benefits are and how each is taxed (or not taxed) can save you and your employees from unpleasant surprises during tax season.
How do taxes and fringe benefits work?
A fringe benefit, sometimes referred to as an employee benefit or perk, is the additional compensation or benefit an employer offers an employee on top of their regular salary or wages. The IRS considers most fringe benefits to be taxable compensation that must be reported on tax forms (e.g., Form W-2, Wage and Tax Statement, and Form 1099-MISC, Miscellaneous Income).
"Fringe benefits that are considered taxable are equal to taxable income and therefore [are] taxed as regular income," Jorge De La Nuez, senior director of payroll, tax, and compliance at Namely, told Business News Daily. "When you receive this type of taxable fringe benefit from your employer, taxes are deducted from your paycheck and reported on your annual tax return."
Key takeaway: The IRS considers most fringe benefits to be taxable compensation, which employees would report just the same as they would for their standard taxable wages (e.g., Form W-2 or Form 1099-MISC).
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What are taxable fringe benefits?
Employers can provide their employees with a variety of desirable benefits; however, it is important to know which ones are subject to taxes (and must be reported) and which benefits are not. Unless otherwise stated by the Internal Revenue Code, an employee fringe benefit is likely taxable to some extent.
Most fringe benefits come in the form of a product or service, as opposed to a cash payment, so they are taxed on their cash-value equivalent based on fair market value.
"This equivalent value is taxable, just like how cash compensation is taxable, except that the employee typically enjoys the benefit in the form of a product, service or reimbursement," said Moses Balian, HR consulting manager at Justworks.
Some of the most common taxable fringe benefits, according to Balian, are:
- Discretionary bonuses (including gift cards)
- Income from exercise of nonstatutory stock options
- Taxable income from issuance or vesting of restricted stock
- Employer-provided cell phone (non-business use)
- Gym memberships
- Employer-provided vehicle or car lease
- Transportation benefits in excess of employer/employee pretax deferrals under a Section 132 Plan
- Housing allowance
- Moving expenses
- Meals and lodging (distinct from business travel)
- Reimbursement for classes or development unrelated to work (e.g., foreign language classes, if those classes are not work-related)
- Travel expenses not related to business (e.g., an extension to a business trip)
- Group-term life insurance (greater than $50,000 of coverage)
In some circumstances, some of these benefits may be nontaxable. For example, De La Nuez said that additional fringe benefits, such as reimbursements, are not taxable at the time of payment to the employee, as they have been paid with post-tax earnings. This can include reimbursements for gym memberships, tuition and internet connectivity.
As you offer a wider variety of benefits to your employees, it is important to keep accurate tabs on your taxation and reporting obligations. Balian recommends finding a payroll service that can help you stay compliant.
"Your payroll platform needs to be sophisticated and straightforward enough to process and appropriately categorize your fringe benefits so as to avoid tax mistakes and potential penalties," said Balian.
Key takeaway: Most fringe benefits are taxed based on their cash-value equivalent and can include things such as bonuses, stock options, gym memberships, housing allowances, and group term life insurance (with coverage in excess of $50,000).
What are nontaxable fringe benefits?
Most fringe benefits are subject to taxation; however, certain benefits are considered nontaxable. In most instances, nontaxable fringe benefits are not subject to federal income tax withholding, Social Security, Medicare or federal unemployment tax (FUTA), and they often do not have to be reported on a W-2 form. However, it is important to know the conditions upon which these benefits are deemed nontaxable, as they can vary on a case-by-case basis.
"Fringe benefits that are considered nontaxable by the IRS are deducted on a pretax basis and [are] usually reported on your annual tax return," said De La Nuez. "While these fringe benefits may be deducted on a pretax basis, certain contributions made to them may be taxable upon withdrawal."
The most common nontaxable fringe benefits include:
- Achievement awards (up to $1,600 for qualified plan awards)
- Adoption assistance
- Disability insurance (This includes employer-paid disability insurance premiums. Most benefits an employee receives under the policy are taxable)
- Dependent care assistance (up to $5,000 per year, as long as it doesn't exceed the earned income of the employee or employee's spouse)
- Educational assistance (up to $5,250 annually)
- Employee stock options (These may be subject to taxes)
- Group-term life insurance (Coverage shouldn't exceed $50,000)
- Health savings accounts
- Medical insurance plans (e.g., health, dental and vision care)
- On-premises athletic facilities
- Lodging and meals (if offered on business premises or as a de minimis fringe benefit)
- Retirement planning services (Some benefits may be tax-deferred)
- Qualified employee discounts (up to certain limits. Employee discounts differ from subsidized memberships)
- Qualified transportation benefits, also known as commuter benefits (up to certain limits)
- No additional cost services
Employers can also take advantage of an affordable, nontaxable fringe benefit option: de minimis benefit. These are benefits with a value so minute that the IRS deems accounting for them to be unreasonable or administratively impractical.
De La Nuez said common fringe benefits that fall into this category can include office snacks or drinks, group meals, birthday or holiday gifts (not cash), employer-provided local transportation, personal use of a business cell phone, and theater or sporting event tickets. [Read related article: Workplace Incentives That Your Employees Want]
"Using these types of fringe benefits go a long way for attracting and retaining top talent while not creating an accounting or administrative burden on the business," said De La Nuez.
Key takeaway: Nontaxable fringe benefits are typically not subject to federal income tax withholding, Social Security, Medicare or FUTA. However, they vary on a case-by-case basis. Check the IRS' website if you're not sure whether a benefit is taxable or nontaxable.
Tips for determining taxable vs. nontaxable benefits
Employers should pay special attention to the nontaxable benefits they offer their employees. According to Balian, many growing businesses make this mistake with tuition assistance reimbursement.
For example, work-related professional development can be reimbursed through a nontaxable expense reimbursement; however, tuition reimbursement for graduate and undergraduate-level courses is nontaxable up to $5,250 per year, and only under a formally established Section 127 Plan. This requires you to have a formal plan document that spells out who is eligible for educational assistance, what exactly is covered, etc. Expenses over $5,250 are taxable. [Read related article: Should You Outsource HR?]
"These [plans] come with strict rules, such as having a plan document, not being offered as a choice versus other forms of compensation, and they must not discriminate in favor of highly compensated employees," said Balian. "Be sure to work with a reputable Section 127 Plan administrator before issuing nontaxable tuition assistance reimbursement to employees."
When you create an employee benefits package, identify each benefit's "taxability," and clearly outline what you are offering in your employee handbook. It is often helpful to work with an experienced benefits administrator to create your benefits package.
Key takeaway: It is recommended that small business owners work with knowledgeable benefits administrators before offering fringe benefits, especially education assistance benefits, to their staff.