Smorgasbord of Fringe Benefits

Now turn to the tax angles of fringe benefits for employees ... giving the most at the least tax cost to them and lowest net cost to firm.

The basic rule is that fringe benefits are taxable compensation. Exceptions are written by Congress ... in the Internal Revenue Code. And there are many exceptions. Some have been around for decades. Others are of more recent vintage, having passed in the last few years.

The tax treatment of the exceptions varies widely: Many fringes are exempt from tax if certain rules are satisfied. Some are tax deferred... no income tax is paid until a later date. Or taxed at lower rates... capital gains on stock of an employer. Even a fully taxed fringe has a plus side ... the tax employees pay is less than the cost would be if employees had to pay for it on their own.

Many fringes must cover almost all employees or become taxable. Some benefit plans cannot cover sole proprietors or partners, which is one of the reasons that many businesses end up incorporating. Most have lids on what can be paid to owner-employees and others.

Breaks on the employer's products or services often are given. Price discounts. Tax free if equally available to all employees and if products are part of firm's business line in which employee works. The discount cannot exceed firm's gross profit. On services, 20% of price to customers ... lower commissions for employees of a broker, for example. The employer can extend such tax breaks to spouses, children and retirees.

Free services, such as tax-free rooms for hotel employees or trips for airline employees. But services must be available on an equal basis to all employees. Otherwise, high-paid employees are taxed on the value received. Reciprocity agreements with others in same line of business are allowed.

Many fringe benefits revolve around transportation or commuting. Company cars are taxable to the extent available for personal use, except demonstrators for full-time salespeople, with limited personal use.

Personal use of company cars by employees can be valued three ways: Annual lease value figured from IRS tables…$1.50 each way for commuting by rank-&-file employees. Or at 321/2 cents per mile for every personal mile by employees, as long as the employer's automobile cost less than $15,600. Transit passes and tokens. Employers can sell them to employees at discounts up to $65 a month... or give cash up to $65 for them tax-free.

Parking: Tax-free if worth up to $175 a month, even if limited to high-paid employees. The excess over $175 per month is taxable income. Limit is indexed to inflation. The entire value of free parking is taxed to partners, 2% shareowners of S corporations and independent contractors. Employees even can have the option of cash instead of parking... will be taxed on the cash, but not if they pick a parking subsidy instead.

And individuals using leased "luxury" cars for business have income that's imputed on autos costing more than $15,500 and first leased in ‘99.

Company planes. Personal use is taxed, unless half of the seats are occupied by employees on business travel. Same for spouses and kids. Airline employees are not taxed if they travel on a space-available basis.

Chauffeurs & bodyguards: Taxable unless for convenience of firm, which exists when there's legitimate concern for security of the employee.

A number of fringe benefits involve meals and entertainment ... often with complex rules spelling out when they are taxable and when not.

Supper money: Tax-free for employees who occasionally work late. However, IRS takes a dim view of habitual supper money payments: Taxes it.

Meals & lodging: Tax-free if on firm's premises and if provided for employer's convenience, like on-premises restaurant meals for servers. Or when paid for by the company to reimburse employees on business travel. And 100% deductible by the employer too ... a change that took effect in ‘98.

Farmers who incorporate have a tax-saving opportunity to explore. Value of their meals and lodging isn't taxed if they must live on the farm in the corporation's residence to run the farm and 24-hour care is needed.

Company cafeterias. Tax-free if open to wide classes of employees other than top executives, officers, owner-employees, high-paid employees. Also, revenue generated must cover direct operating expenses of facility.

Company parties & picnics: Tax-free when on an occasional basis.

Executive dining rooms: Tax free if eating on company's premises is clearly for convenience of employer or if the employee also could take a tax deduction for the cost of the meal as a valid business expense.

Club memberships. Taxable unless the business use predominates. But employer can opt to treat payment of dues as compensation to employee.

Entertainment allowances. Not taxable to extent used on business.

Vacation facilities: taxable, even if available to all employees.

Company gym and athletic facilities. Not taxed when all employees can use the facilities and the facilities are on the premises of employer.

Education benefits depend on whether courses are job-related. Tuition paid for job-related courses is tax free to employees ... and fully deductible by the employer. There is no limitation on how much. To be job-related, a course must improve skills used on the current job ... cannot be needed to meet minimum requirements for the job or to qualify for a new line of work, such as getting a law degree or most MBA programs.

Payments for up to $5,250 of NON-job-related courses are tax free, only for UNDER-graduate courses before June’00. Cost of post-grad studies is taxable income to employees unless the courses qualify as job-related. Several requirements for the $5,250 exclusion must be followed: The tuition plan must be in writing. The employer must notify employees about the plan. And no more than 5% of total tuition payments for a year can be made to owners of 5% or more of the company or to their relatives.

Tuition breaks for teachers' kids: Tax-free unless heavily tilted toward high-paid. This break does not cover tuition for graduate school.

Faculty housing: No tax if rent is 5% or more of appraised value.

Day care: Tax free up to $5,000 a year when company wide.

Financial counseling: Taxable, even if offered to all employees. Itemizers can deduct the value of this, but it is subject to the 2% rule.

Low-interest loans: Employees are deemed to have received income because of the arrangement ... generally equals the interest they didn't pay. They may get offsetting deductions for phantom interest paid the employer, depending on whether funds are for investment, business or home mortgage.

The tax impact on employers must be weighed too... income employees could earn with loan proceeds might generate taxable income for employers.

Gifts. No tax if gifts are small ... for holidays, birthdays, etc.

Employee achievement awards: Tax-free if for length of service or safety achievement. Also must be tangible personal property, not cash, and must cost the employer $400 or less ... $1,600 for awards that are made under a written plan that does not discriminate in favor of high-paid.

Employer-subsidized health benefits are a major fringe benefit. The employer can pay all or only a portion of the tab for health insurance or let employees share some or all of it. Merely offering a group rate that employees pay probably costs them less than their own policies would.

Benefits aren't taxable, except in some self-insured arrangements.

Nor are the premiums employers pay ... not taxable to the employees.

But reimbursements to officers, owner-employees, etc., are taxed in self-insured plans that do not cover a large share of firm's employees. Arrangements with insurance companies to handle employee medical claims and charge the employer accordingly are classified as self-insured plans.

Annual physicals can be required as a condition of employment. Cost or reimbursement is tax free, even when required only for top executives. But firms must offer continuation coverage to employees who quit, retire, are disabled, etc., or their families. Can pass costs on to them. And requirements for covering preexisting conditions now apply... for plan years that begin after June '97. There are a few exceptions.

Proprietors and partners can deduct 60% of premiums for themselves and their families as a business expense. The remainder can be deducted if itemizing medical costs. Ditto for employee-owners of S corporations.

Self-employed can deduct 100% now by hiring spouse and providing family coverage for employees, IRS says. Spouse must be a real employee.

Small companies have a new option on health insurance for employees. Can make contributions to medical savings accounts ... MSAS. Only employees in small firms and self-employed can have MSAS. Small companies that employed an average of no more than fifty people in either of the two previous years ... workforce can grow to 200 employees.

Paying to MSAS are fully deductible by employers who make them on behalf of their employees having no basic medical insurance protection. Employers offering MSAS must do so for all their eligible workers.

MSA owners cannot have basic health insurance ... the typical plans that cover most ailments, with small deductibles and co-pay requirements. MSA is supposed to be tapped to pay what basic coverage would have paid.

Owners must have high-deductible coverage. Insurance deductibles for self-only coverage must be at least $1,550 a year... and up to $2,300. For family coverage, the deductible must range between $3,050 and $4,600, and the family deductible must be met before insurance pays any benefits.

The policies also must limit co-payments on covered benefits ... to $3,050 for self-only coverage, $5,600 for married couples and family coverage.

But insurance against accidental injury or disability is allowed. Also dental, vision or long-term care, medicare supplemental, cancer, etc.

Contributions are tax free to employees ... up to 65% of deductible for single coverage or 75% of family coverage deductible. Maximum pay-ins are $1,495 for individual coverage ... and $3,345 when covering a family. Employees are taxed on company pay-ins in excess of the 65% and 75% limits. MSA cannot be set up via salary-reduction plans or under cafeteria plans.

The income earned within an MSA is not taxed to the MSA owner. Withdrawals used to pay medical bills are not taxed if those bills are for medical treatment of someone covered by the high-deductible plan. However, pay-outs are taxed if reimbursing premiums for other insurance.

There is a 15% penalty on pullouts used for non-medical purposes, in addition to the regular tax, if the withdrawal occurs prior to age 65.

There is a limit on the number of MSA allowed ... only 750,000. New MSA cannot be set up after ‘00 unless Congress extends the program.

Group-term life is another popular benefit employers can provide. First $50,000 of insurance is tax-free. Premiums for the excess above $50,000 are hit by income and social security taxes. But tax paid is far less than the employee would pay for similar individual coverage. Must cover 70% or more of help ... or only 15% of insured can be top executives. Must be convertible if employee quits, needn't provide any break on price.

Discriminatory policies are fully taxed to key employees covered. Retirees still can be covered... on the same basis as employees.

Firms with fewer than 10 employees have special rules: Must cover ALL full-time employees. Coverage must be a uniform percentage of pay or based on tables that satisfy IRS rules. Physicals cannot be required, although employees can be required to fill out a medical questionnaire.

Group PERMANENT insurance costs more, but gives more to employees. Employee is taxed on employer-paid premiums that build up the cash value. But if changing jobs, can buy policy from employer and pay future premiums.

Split-dollar coverage is a valuable low-tax way to pay key people. The employer and employee split the premiums and benefits of the policy. Firm pays for and gets the cash value ... employee's heirs receive balance. Employee pays for term-insurance portion... is taxed on part employer pays.

Employers can provide long-term care coverage for workers tax free, just like company-paid health insurance, for up to $175 a day. Over that, the benefit is taxable income, unless offset by the cost of long-term care.

Disability or sick pay can provide some valuable tax breaks too: Employees aren't taxed on insurance premiums that employers pay... whether a group insurance policy or individual policies for key employees. Benefits are taxed unless employee pays premiums. Some low-paid under 65 and permanently disabled can get a tax credit to ease their burden a bit. Social security tax also is due on the first six months of such sick pay.

Adoption assistance. Employers can provide up to $5,000 tax-free, $6,000 for adopting a child with special needs. Covers attorney's fees, court costs, adoption fees and travel expenses, including meals & lodging. Available for foreign adoptions too. The break phases out for employees with adjusted gross income over $75,000 ... disappears entirely at $115,000.

Employees can claim a tax credit for excess adoption expenses.

Cafeteria plans let employees take cash or some tax-free benefits, including health insurance. Other benefits that can be offered that way are group-term life, dependent care, 401(k) pay-ins and longer vacations, but not parking, tuition, long-term care or employer-provided meals, etc. In effect, employees can tailor fringe benefit packages to their needs ... can buy extra health insurance or skimp on that and fulfill other needs.

Flexible spending accounts are a narrow variety of cafeteria plan. Employees agree to reduce their pay, with the reduction put into accounts that they can tap for medical and dependent-care expenses during the year. Employees pay less income tax because their pay is lower. They also save because the expenses are paid with pre-tax dollars. Employers save too ... pay less in FICA and Medicare taxes because employee salaries are reduced.

There is one risk worth noting: "Use it or lose it" applies ... employees forfeit any money that remains unspent in accounts at the end of the year.

Employers must file reports with the government on various benefits, usually part of the 5500 form series put out by IRS. The reporting rules should be checked out ... vary with type of benefit, number of employees.

Tax-qualified retirement plans are another key area for fringes. Qualified plans - offer three tax breaks that make them attractive: Deductible pay-ins. Tax-free income build-up. Low-taxed pay-outs.

Firms have many options: Pension plans. Profit sharing. 401(k). Plans can be used to give workers a stake in the firm by giving them stock or options to purchase stock in the company... or to spur savings by them.

Main difference between pension and profit sharing plans is this: Employers with pension plans are obligated to make annual contributions. Not so with profit sharing ... pay-ins depend on whether there is any profit.

Other differences: Pensions promise specific retirement amounts, such as a set percentage of pay for the final year or series of years. Profit sharing and money purchase plans don't promise a specific benefit. Employees get the current worth of the company contributions to the plan. Many pension plans are insured by the government ... profit sharing plans aren't.

There are many similarities: Limits on favoring owners, officers, high, paid employees. Company pay-ins can be tied to pay. Must cover most workers, including those in other firms owned by same people. The size of benefit can be linked to time with firm... cannot require staying until retirement. If most of the plan benefits go to top aides, faster vesting is required.

401(k) plans are a growing retirement arrangement for employers, replacing older alternatives where employers put up the bulk of the money.

They work this way: Salary or bonuses are diverted to an account and invested as employee directs, with some limits allowed on the choices. Pay-in is free of income tax, but social security and medi-care taxes apply. Employees can put as much as $10,000 in a 401(k) ... could be $10,500 by '01.

Employer can match employee pay-ins ...added impetus to participate.

But pay-ins by high-paids are capped... those who make over $80,000 a year or own more than 5% of the company or are related to one who does.

The amount that high-paid can set aside depends on the aids. As a percentage of pay, highs can put in up to 125% of the percent of pay low-paid put in. Or, if larger, up to 2% of pay more than low-paids do so long as that percentage isn't more than twice what low-paid set aside. For simplicity, companies can use prior year's percentages for low-paid. Any excess deferrals must be returned as taxable income to high-paid.

The key is to get rank-&-file to participate as much as possible. Firms now have an easier time meeting non-discrimination rules. Starting this year, pay-ins by high-paids needn't be tied to what others do in if employer matches at least 100% of the first 3% of pay plus one-half of next 2% the low-paids put in. Or firms can put in 3% for all low-paids Exempt groups now can have 401(k) ... but not state & local governments.

Small firms have an easy way of setting up tax-qualified plans ... simply adopt a master or prototype plan approved by IRS. Scads of them. Life insurers, mutual funds, banks, benefit advisers and others have them. But check whether sponsor will keep the plan current: ...amend as law requires.

Smalls have a new option... companies with 100 or fewer employees:

SIMPLES, standing for Savings Incentive Match Plan for Employees. SIMPLE require a match for employees paid $5,000 or more in ‘97, ‘98, ‘99. Match can equal what employees put in, up to 3% of pay or 2% of their pay up to $160,000. They can be set up as IRAs, with a maximum total pay-in of $12,000 or as 401(k) plans, with a maximum combined pay-in up to $10,800.

Employees can put up to $6,000 in a SIMPLE. Ditto for partners and proprietors ... matches for them don't count toward the $6,000 limit. Unlike 401(k), high-paid can put in $6,000 no matter what low-paid does.

The pay-out side of retirement plans should be kept in mind: Plan pay-outs needn't start until retirement for most employees. But plan distributions must begin by April 1 of year after reaching 701/2, for those owning more than 5% of the firm... and those retiring before 701/2. Pay-outs can be taken as an annuity... for life, a period of years or joint & survivor. But spouse must consent to waiving joint & survivor.

Or taken as a lump sum, with choices as to what to do with pay-out. Income tax can be delayed by making a rollover to an IRA. Then, pay-outs are taxed as made from the IRA. However, distributions must start by April 1 of the year after reaching age 701/2, even if still on the job.

Special averaging is an option for some. Those born before ‘36 can use 10-year averaging and a 20% rate on pre-‘74 earnings appreciation. Those over 591/2-, can use 5-year averaging on lump sums, but only through ‘99.

Pay-outs in employer stock can qualify for capital gain rates: The appreciation can be taxed at only a 20% tax rate when shares are sold if a long-term capital gain. But break is lost if stock is put in an IRA.

There are penalties for excessive benefits and early pay-outs. Penalties apply when pay-outs are received too soon... generally 10% if paid before 59,1-, unless paid out as an annuity or because of disability.

An extra 15% tax on big pay-outs no longer applies to plans or IRAs, the 15% penalty on annual pay-outs exceeding $160,000 or lump sums exceeding $800,000 has been permanently repealed. But income taxes still are due.

And the extra 15% estate tax is no longer in effect ... ended in '97.

Non-profit groups can have some types of tax-qualified plans too. 401(k) as we said before. And 403(b) annuities, which many teachers have. Maximum pay-in is $10,000, as a general rule ... should reach $10,500 by ‘01.

Non-qualified deferred-pay plans are used to reward key employees. There are many types of non-qualified plans ... can defer tax on current pay or provide retirement benefits in excess of the limits on qualified plans.

Employee isn't taxed until paid ... firm gets no deduction till then. But if assets are set aside to fund benefit, employee is taxed immediately unless firm's creditors have right to grab assets before employee is paid. IRS has issued model language for firms that want to establish these plans.

Non-qualified stock options. Can involve actual receipt of stock. Or give employees "units" representing stock ... with actual payment in cash tied to increase in value of stock. Performance shares are a variation... payoff tied to fixed goals. Stock-appreciation rights ... payoff in stock.

The future: Fringe benefits are part of current policy differences these days, differences over the role of government, the deficit, tax cuts and tax reform.

Tax breaks still are being enacted to encourage certain actions, and fringe benefits are no exception. In ‘96, medical savings accounts, SIMPLE and tax breaks for long-term care and adoptions were enacted.

Now, bigger child-care breaks and pension changes are being eyed. Pressure on government spending often spur tax breaks as a backdoor way of paying for what government cannot afford. Thus, breaks for long-term care will ease some of the burden facing medi-care when baby boomers retire.

Giving favorable treatment to benefits is a tax cut in disguise for employees and employers in a position to make use of such advantages.

But curbing fringe benefits is eyed as a way lowering tax rates, which is at the heart of the movement towards a flat tax... simplify taxes by eliminating tax breaks so that tax rates can be drastically reduced.

All of which means fringe benefits will be in flux for many years.

Courtesy of The Kiplinger Tax Letter’s Federal Tax Reduction Kit

 

 

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