Learn more about the taxability of fringe benefits.
Providing fringe benefits, such as free commute, meal plans or health insurance, to someone who has performed a service for you, is a transaction that is taxable and should be included in the recipient’s pay. It is not taxable only when the law specifically excludes it.
Correctly accommodating tax in your computation for fringe benefits and salary is important. When including taxable benefits in pay, you include the amount by which the value of the fringe benefit you provide exceeds the sum of the following:
- Any amount the law excludes from pay
- Any mount the recipient paid for the benefit
Reporting Fringe Benefits
The nature of your employee’s job or position affects the taxes imposed on the benefit, as well as the type of form you must use when reporting the benefit.
The benefit is subject to employment taxes when the recipient of a benefit is your employee. It must be reported on Form W-2, Wage and Tax Statement. There are special rules you can apply to withhold, deposit, and report the employment taxes.
On the other hand, if the recipient of the taxable fringe benefit isn’t your employee, then that benefit is not covered by employment taxes. You may still have to report the benefit in an information return. If the recipient is an independent contractor, use Form 1099-MISC and Miscellaneous Income. If the recipient of the taxable benefit is a partner, use the forms Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, and Credits.
What are Cafeteria Plans?
A cafeteria plan, including an FSA or flexible spending arrangement, allows participants to receive qualified benefits on a pre-tax basis. Employees have the choice between receiving cash as compensation or taxable benefits.
If your employee chooses to receive a qualified benefit under the plan, the qualified benefit would not be taxable because the employee had the choice to receive cash instead.
Usually, a cafeteria plan doesn’t include any plan that offers a benefit that defers pay. But it can include a qualified 401(k) plan. Some life insurance plans by educational institutions can also be offered as a benefit even though they defer pay.
Qualified employment benefits
The following are benefits an employee can choose to receive:
- Accident and health benefits
- Adoption assistance
- Dependent care assistance
- Group-term life insurance coverage (including costs that can’t be excluded from wages)
- Health savings accounts (HSAs).
Employment Benefits that are not allowed
- Archer MSAs
- Athletic facilities
- De Minimis (minimal) benefits
- Educational assistance
- Employee discounts
- Employer-provided cell phones
- Lodging on your business premises
- Moving expense reimbursements
- No-additional-cost services
- Retirement planning services
- Scholarships or fellowships
- Transportation (commuting) benefits
- Tuition reduction
Limits and Conditions on Providing Health FSA
There is now a contribution limit on a health FSA. Cafeteria plans with plan years beginning after December 31st 2016 may not allow an employee to request salary reduction contributions for a health FSA in excess of $2,600.
If the health FSA contributions to the dollar limit are not limited, the cafeteria plan would not be treated as a cafeteria plan. All of the benefits offered would be includible in the employee’s gross income.
There is also a “use-or-lose” rule for health FSAs. This means that instead of a grace period, there is the option to amend your cafeteria plan to allow up to $500 of an employee’s unused contributions to carry over to the immediately following plan year.
Provision of Cafeteria Plans to Employees
For these plans, the following individuals are treated as employees:
- A current common-law employee
- A full-time life insurance agent who is a current statutory employee
- A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction or control
There is an exception for S corporation shareholders, which states that you shouldn’t treat a 2% shareholder of an S corporation as an employee of the corporation for this purpose.
A 2% shareholder directly or indirectly owns more than 2% of the corporation’s stock. They can also be defined as owning stock with more than 2% of the voting power. This condition can apply at any time of the year. Instead of being treated as an employee, your processing of their benefit should be in the same way as you would a partner. The benefit shouldn’t be treated as a reduction in distributions to the 2% shareholder.
There are plans that favor highly compensated employees. With a plan like this, you have to include in their wages the value of taxable benefits they could have selected. A plan under a collective bargaining agreement is not a plan that favors highly compensated employees.
A highly compensated employee is someone who is:
- An employee who is highly compensated based on the facts and circumstances
- A shareholder who owns more than 5% of the voting power, or value of all classes of the employer’s stock
- An officer of your company
- A spouse or dependent of a highly compensated employee, as defined above, is also considered for this type of plan.
There are also plans that favor key employees. A plan favors key employees if more than 25% of the total of the nontaxable benefits you provide go to recipients defined as key employees. Given this kind of plan, you need to include in their wages the value of taxable benefits they could have selected. Similarly, a plan you maintain under a collective bargaining agreement doesn’t favor key employees.
A key employee during 2017 is generally an employee who is either of the following:
- An officer who has an annual pay more than $175,000
- An employee who is 5% owner of your business, or a 1% owner of your business with an annual pay more than $150,000, for 2017
Simple Cafeteria Plans
An eligible employer can establish a simple cafeteria plan as long as they meet contribution requirements and eligibility and participation requirements. Simple cafeteria plans are treated as meeting the nondiscrimination requirements.
An employer is considered eligible if they employ an average of 100 or fewer employees during either of the 2 preceding years. Other conditions that can define eligibility include:
- If your business wasn’t in existence throughout the preceding year and you reasonably expect to employ an average of 100 or fewer employees in the current year.
- If you establish a simple cafeteria plan in a year that you employ an average of 100 or fewer employees, and you don’t employ an average of 200 or more employees in a subsequent year.
The eligibility and participation requirements mentioned above are met if all employees who had at least 1,000 hours of service for the preceding plan year are eligible to participate. Each employee eligible to participate in the plan should be able to elect any benefit available under the plan.
These requirements have some exceptions. You can exclude from the plan employees who:
- Are under age 21 before the close of the plan year
- Have less than 1 year of service with you as of any day during the plan year
- Are covered under a collective bargaining agreement
- Are nonresident aliens working outside the United States whose income didn’t come from a U.S. source
Lastly, you must make a contribution to provide qualified benefits on behalf of each qualified employee in an amount equal to:
- A uniform percentage (not less than 2%) of the employee’s compensation for the plan year; or
- An amount which is at least 6% of the employee’s compensation for the plan year or twice the amount of the salary reduction contributions of each qualified employee, whichever is less.
If you are meeting the contribution requirements with the qualified benefits equaling an amount at least 6% of the employee’s compensation for the year or twice the amount of the salary reduction contributions of each qualified employee, note that the rate of contribution to any salary reduction contribution of a highly compensated or key employee can’t be greater than the rate of contribution to any other employee.