2022 Year-End Reminders Regarding Common Fringe Benefits, Special Rules for 2% S Corp Shareholders
2022 Year-End Reminders Regarding Common Fringe Benefits, Special Rules for 2% S Corp Shareholders
As 2022 draws to a close, employers should review whether they have properly included the value of common fringe benefits in their employees’ and (if applicable) 2% S corporation shareholders’ taxable wages. This is especially true for 2022, since COVID brought about relief that changed some rules relating to traditional fringe benefits and found many employers dealing with a remote workforce.
Fringe benefits are defined as a form of pay for performance of services a company provides to its employees as a benefit; the value of those benefits must be included in an employee’s pay unless specifically excluded by law. The actual value of the fringe benefits provided must be determined annually before December 31 to allow for the timely withholding and deposit of payroll taxes. Failure to properly report includible fringe benefits to the recipient and the IRS on Form W-2 or Form 1099 before January 31, 2023, may result in penalties.
This alert provides a review of the rules on the identification of and tax reporting requirements for several fringe benefits that employers typically offer to their employees. The alert also discusses the special treatment of several fringe benefits that were made available under various COVID relief provisions, as well as what may be new considerations for employers dealing with a remote workforce.
Remote Workforce Fringe Benefits
Many businesses are now allowing employees significant flexibility in choosing their work location. A common work arrangement allows an employee to regularly work from home and to work in the employer’s office as needed. Employers are asking whether the expenses incurred by these employees to travel to the office can be reimbursed on a tax-free basis. The employee’s home might be in the same or different geographic area as the office. The answer hinges on whether the travel from the employee’s workplace in their personal residence to the employer-provided office is considered a personal commute or a business trip. This BDO Tax Strategist article explains that employers should exercise caution when determining the tax consequences of costs incurred for employee travel between their personal residence and the employer’s office or another work location.
Many employers reimburse employees for their reasonable home office expenses. For these reimbursements to be tax-free (as an Internal Revenue Code (IRC) Section 132 working condition fringe benefit), employees must provide receipts for amounts over $75 to substantiate the business expenses, which might include the cost of a desk, chair, equipment, internet, utilities, etc. Some employers prefer to pay a periodic flat dollar “allowance.” But such allowances are treated as taxable wage income (i.e., subject to both income and employment tax withholding and the employer’s share of employment taxes) if employees do not substantiate how the funds were used. IRS rules require that the employer maintain an “accountable plan” for such reimbursements to be tax-free (see “Employee Business Expense Reimbursements and Allowances” below).
Reimbursements must be for business expenses (not personal expenses). To constitute a business expense, the employee’s home office must be used exclusively as such, for the convenience of the employer, not the employee. Also, when an employer reimburses an employee for furniture or equipment, those items belong to the employer. Ownership of business property could create “nexus” with the state or local area where the items are located, possibly subjecting the employer to tax or other rules in that area. When an employee terminates employment, the fair market value of the property would be imputed taxable wage income to the employee if the employee does not return the property to the employer.
Many employers provide tax-free meals to employees during meetings or when they are working on pressing projects. In addition, many employers provide tax-free snacks and beverages in a break room. Some employers want to continue to provide such tax-free meals or snacks to remote employees who generally work from home. Under current IRS rules, it is difficult to justify the business purpose of such meals or snacks. Each situation depends on its own facts and circumstances. Additionally, meals for employees that travel a long distance from their home when called to the office might not qualify for treatment as tax-free meals while away from home on business if the employer derives no benefit from the employee living a long distance from the office.
Common Employee Fringe Benefits
Up to $50,000 of group term life insurance coverage is excluded from tax. Any amount in excess of $50,000 must be included in an employee’s taxable income and is subject to Social Security and Medicare taxes (FICA). Even though any amount of coverage exceeding $50,000 is included in taxable wages, withholding of federal income tax (FIT) and state income tax (SIT) is not required. However, employers may withhold at their option. The amount of coverage must be reported as wages in Boxes 1, 3 and 5 of the employee's Form W-2 and in Box 12 with code “C.”
If premiums for group long-term disability (LTD) or short-term disability (STD) are paid with pre-tax dollars, generally, the proceeds received by employees who become disabled will be taxable income. Conversely, if LTD or STD premiums are paid with after-tax dollars, generally, the proceeds would be tax-free. Combination funding is also possible. Employers may pay some, all or none of the premium. Complex tax rules apply to those situations that are beyond the scope of this summary.
Any payments of an allowance or the reimbursement of business expenses for which the employee does not provide an adequate accounting (i.e., substantiation with receipts or other records), or for which the employee does not return any excess allowance or reimbursement to the company, are considered to have been provided under a non-accountable plan and are required to be treated as taxable wages for purposes of federal and applicable state and local income tax withholding, employer and employee FICA tax, and federal and state unemployment taxes (FUTA and SUTA).
However, if the employee provides an adequate accounting of the expenses incurred, or is “deemed” to have substantiated the amount of expenses under a per diem arrangement, the reimbursement amounts are excludable from taxable income and wages.
Determining whether expenses incurred by employees that voluntarily elect to work from home are business expenses incurred for the benefit of the employer requires additional scrutiny before treating the reimbursements as tax free under an accountable plan.
Employers that fail to withhold on payments that are erroneously treated as tax free will most likely be liable for the income taxes that they failed to withhold if audited by the IRS.
Generally, anything of value that an employer provides to an employee is included in the employee’s taxable wages, unless an exception applies. Since COVID-19 was declared a national emergency on March 13, 2020, employers can use IRC Section 139 to make tax-free, tax-deductible “qualified disaster payments” to employees. These payments can be made on a tax-free basis until the COVID-19 national emergency declaration has been formally lifted by the president of the United States. Even though the declaration was in effect during 2022, employers should exercise caution in using Section 139 in 2022 (and beyond), since much has returned to normal. For example, schools are open, mass transportation systems no longer impose restrictions, large gatherings are permitted without restrictions, etc. Thus, it has become more difficult to say that “but for COVID” the expenses would not have been incurred by the employee.
As a reminder, qualified disaster payments are payments made by an employer to an employee that are not reimbursed by insurance and are reasonably expected by the employer to:
- Reimburse or pay for reasonable and necessary personal, family, living or funeral expenses incurred as a result of a qualified disaster; and
- Reimburse or pay for reasonable and necessary expenses incurred to repair or rehabilitate a personal residence or repair or replace its contents to the extent that the need for such repair, rehabilitation or replacement is attributable to a qualified disaster.
The payments cannot include luxury or decorative items or services.
With respect to COVID-19, employers were able to pay for or reimburse expenses (or provide benefits in kind) the employer reasonably believed resulted from the COVID-19 national emergency that are not covered by insurance. For example, employers paid for, reimbursed or provided employees with tax-free payments for over-the-counter medications, hand sanitizers, home disinfectant supplies, child care or tutoring due to school closings, work-from-home expenses (for example, setting up a home office, increased utilities expense, higher internet costs, using an in-home printer, and increased cell phone costs), increased costs from unreimbursed healthcare-related expenses and increased transportation costs due to work relocation (such as taking a taxi or ride-sharing service from home instead of using public mass transit).
There is no Form W-2 or 1099 reporting requirement for IRC Section 139 payments.
Employers who have been using Section 139 may want to revisit their practices and procedures to determine if such payments or reimbursements still qualify as qualified disaster relief payments.
Employers may provide tax-free education to current employees as a working condition fringe benefit under IRC Section 132. There is no specified limit on the amount of education expenses that can be paid or reimbursed on a tax-free basis, but the course or training must be job-related and satisfy other IRS requirements.
Expenses, up to $5,250 per year, that don’t satisfy the requirements as a working condition fringe benefit can be paid or reimbursed as tax-free employee education assistance under an IRC Section 127 plan that meets the following requirements:
- The tuition plan must be in writing and communicated to the employees with reasonable notice
- Payments cannot discriminate in favor of highly compensated employees, and no more than 5% of the amounts paid can go to shareholders or owners (i.e., those who own more than 5% of the company’s stock or capital interests on any day of the year)
- Employers cannot give employees a choice between educational assistance and other compensation
- The student loan debt must be for the employee’s own education (in other words, student loan debt payments cannot be made towards the education of an employee’s child or spouse)
The 2020 CARES Act expanded eligible IRC Section 127 benefits to include student loan debt repayments. The inclusion of student loan repayment benefits was originally scheduled to expire on December 31, 2020, but subsequent legislation extended the tax-free treatment of this benefit through December 31, 2025. Many employers are reevaluating the recruiting and retention value this benefit provides, vis-à-vis its cost, especially in light of the federal initiative to forgive certain student debt announced by President Biden in 2022.
In order to recruit new employees and hopefully create loyalty that improves retention, businesses are increasingly interested in paying for education expenses for prospective employees. For example, some businesses pay for nursing, engineering, business or other schooling, provided the individual agrees to accept employment for a specified period after graduation. Many companies are surprised that even though the individual is not an employee when the payment is made, and even if the tuition is paid directly to the school, such payments must be treated as taxable wage income for the individual, reportable on Form W-2 (not on Form 1099). Such payments are subject to income and employment tax withholding, which might require an additional payment by the company via a gross up calculation, since there is no cash associated with the taxable wage calculation.
Bona fide loans may not generate current taxable compensation. But if the bona fide loan is forgiven and the individual accepts employment, the employee will have taxable wages from the forgiveness of debt, reportable on Form W-2 subject to all income and employment tax withholdings.
Many people are now working from home and have greater flexibility to spend time on personal matters without being charged for paid time off (PTO). Also, many vacations and voluntary medical procedures were cancelled or cut back due to COVID concerns. Even routine doctor visits require less time off due to the widespread availability of virtual, on-line services. On the opposite end of the spectrum, essential employees might not have PTO approved because there is no one to perform their duties while they are away. For these and many other reasons, employees are taking fewer PTO days and therefore are at risk of forfeiting some of their accrued PTO.
While most employers hate to see employees forfeit earned PTO, there is no single approach to avoid this situation that is agreeable to all employees. Mandatory cash-outs are not always well received because every employee has a different plan for PTO usage. Voluntary cash-out programs can have unexpected tax consequences to employees that prefer to keep their PTO for future use.
As an alternative to forfeiting excess PTO accruals, some employers facilitate donation of unused PTO either to charity or to other employees who need it.
If handled incorrectly, both the donating employee and the recipient employee may have taxable income. However, properly following the rules regarding paid leave donation programs avoids inclusion of the donated PTO in the donor’s Form W-2 and treats it as taxable W-2 compensation only to the recipient employee.
Employers can create leave-sharing programs either for medical emergencies (including extended time off due to the death of a spouse, child or parent), or for federally declared disasters (or for both, but slightly different rules apply to disaster relief plans). The plan(s) should set limits on how much leave any employee can donate each year and include a detailed procedure for employees to submit a written request for leave (and the request should describe the specific circumstances that necessitate the leave). Donors cannot specify who will receive their donated leave. Generally, recipients can receive donated leave only after exhausting all other PTO. Recipients are paid for the donated leave at their regular rate of compensation. The employer should confirm that all leave transferred under the plan is used for the specified situation. Generally, donated disaster PTO that is not used by the end of the disaster period must be returned pro-rata to the donors who are still employed by the employer.
IRS Notice 2021-42 provided that cash payments made by employers during 2021to charities that provide relief to COVID victims in exchange for employees forgoing PTO are not taxable wages for the donor-employees. Donor-employees could claim a charitable deduction for the donated leave. Employers could deduct these cash payments as a business expense or as a charitable contribution deduction if the employer otherwise met those requirements. Recipients had to be charitable organizations, including national, regional and faith-based organizations that assisted victims of the COVID pandemic. Although this COVID relief was available for 2020 and 2021, it was not available in 2022. However, IRS Notice 2022-28 allows similar relief for employee leave donations made by an employer during 2022 to charities that aid victims of the Russian invasion of Ukraine. Periodically, the IRS announces that certain disasters or emergencies qualify for this special tax treatment.
The value of a company car used for personal travel must be treated as additional wages at a frequency chosen by the employer--up to and including on an annual basis--unless the employee reimburses the employer for such personal use.
FIT withholding on fringe benefit wage additions can be calculated as a combined total with regular wages or generally can be withheld at a flat 22% supplemental wage rate if the employee earns under $1 million.
Alternatively, employers can choose not to withhold FIT if the employee is properly notified by January 31 of the year in which imputed income for personal use of a company car will arise or 30 days after a vehicle is provided and the value is properly reported on a timely filed Form W-2. But employers must withhold FICA taxes on such benefits.
For administrative convenience, an employer can calculate the value of personal use of a company vehicle for the current year based on the 12-month period beginning November 1 of the prior year and ending October 31 of the current year (or any other 12-month period ending in November or December) if the employee is properly notified no earlier than the employee’s last paycheck of the current year and no later than the date the Forms W-2 are distributed. Once this valuation period is elected, the same accounting period generally must be used for all subsequent years with respect to the same automobile and employee.
Many companies have moved away from providing company cars and instead make cash payments to reimburse the employee for the business use of his or her personal vehicle. Car allowances paid in cash without any substantiation of business use are fully taxable and subject to FICA, FUTA, FIT and SIT withholding.
This fringe benefit (unless reimbursed by the employee to the extent permitted under FAA rules) is subject to FICA, FUTA, FITW and SITW. The value of the benefit is calculated based on the Standard Industry Fare Level formula provided by the IRS. Expenses related to personal entertainment use by officers, directors and 10%-or-greater owners that exceed the value treated as compensation to key employees are nondeductible corporate expenses.
Reports indicate that both personal and business use of company aircraft has increased in 2022 because of COVID-19 and other complications with commercial airlines (e.g., staff shortages, schedule changes, long lines at airports, etc.), so some employers may need to address this issue for 2022, even if they have not encountered it in past years.
De minimis benefit amounts can be excluded when the benefit is of so little value (taking into account the frequency) that accounting for it would be unreasonable or administratively impractical. It is a common misconception that if a fringe benefit amounts to less than $25, it is automatically considered a de minimis benefit. However, there is no statutory authority for this position.
If a fringe benefit does not qualify as de minimis, generally the entire amount of the benefit is subject to income and employment taxes (FICA, FUTA, FITW and SITW). Season tickets to sporting or theater events, use of an employer’s residence, apartment, boat or vacation home, and country club or athletic facility memberships do not qualify as de minimis benefits. De minimis benefits have never included cash, gift cards or certificates or cash-equivalent items, regardless of their amount. Gift cards or certificates that cannot be converted to cash and that are otherwise a de minimis fringe benefit redeemable for only specific merchandise such as a ham, a turkey or another item of similar nominal value might be excludable from income. However, gift cards or certificates that are redeemable for a wide variety of items are deemed to be cash equivalents. Any portion of a gift card or certificate that is considered a cash equivalent should be included in the employees’ Forms W-2 and subject to income and employment taxes as detailed above.
While snacks and meals provided to employees can meet the de minimis requirements, they often do not. Still, most employer-provided meals are excluded from the employees’ taxable income under the accountable plan rules for working condition fringe benefits. The employer’s deduction for these meals generally is limited to 50% of food and beverage expense for quiet business meals with customers and clients (i.e., no entertainment is involved). Under special COVID relief designed to help the restaurant industry for 2021 and 2022 only, employers can generally deduct 100% of business meals purchased from a restaurant if the business owner or an employee is present when the meal is provided and the expense is not lavish or extravagant. Entertainment expenses, even with a business purpose, generally are not deductible. But food or beverage expenses related to employee recreation, such as holiday parties or annual picnics, are fully deductible when provided primarily for the benefit of rank-and-file employees.
Caution: We have seen the IRS take an aggressive position on examination, with the agent proposing that the company expenditure for on-site food and beverages regularly furnished to employees should be treated as employee compensation because it is too frequent or extravagant to be excludible as a working condition or de minimis fringe benefit.
This fringe benefit is subject to FICA, FUTA, FITW and SITW. In general, employee achievement awards, gifts and prizes that do not specifically qualify for exclusion are deductible by the employer only up to $25 per person per year, unless the excess is included as taxable compensation to the recipient. Any gifts to employees in excess of $25 per person per year in the form of tangible or intangible property are taxable wage income for employees. There are two exceptions to the general rule: (i) achievement awards for length of service or safety and (ii) certain non-cash achievement awards, such as a gold watch at retirement or nominal birthday gifts, which fall within the exclusion for de minimis benefits.
For a length of service or safety award to be considered excludible, there must be a meaningful presentation of the award, the employee being recognized for the award must have at least five years of service and the award cannot have been granted to the same employee in any of the prior four years. The exclusion applies only for awards of tangible personal property and is not available for awards of cash, gift cards or certificates or equivalent items. The exclusion for employee achievement awards is limited to $400 per employee for nonqualified plans (unwritten and discriminatory plans) or up to $1,600 per employee for qualified plans (written and nondiscriminatory plans).
Moving expenses incurred during 2022 that are paid by an employer must be included in the employee’s taxable compensation unless the employee is an active duty member of the U.S. Armed Forces and is moving to a permanent change of station. The exclusion from employee income is scheduled to be reinstated on January 1, 2026. Employers can still pay (and obtain a deduction for paying) employee moving expenses, but those amounts are now taxable wages paid to the employee.
Employers cannot deduct expenses incurred in providing qualified transportation fringe benefits to employees. Tax-free transportation fringe benefits may still be provided to employees, but the employer will not get a deduction for providing such tax-free benefits. On December 16, 2020, the IRS published final regulations on how to calculate the disallowed deduction for employee qualified transportation costs. While the final regulations generally follow the proposed rules, they include some helpful new positions and simplified methodologies on how to determine the cost of employee parking. For example, parking in some remote areas may be treated as having no value, so the deduction is not disallowed. The payroll tax treatment of employee parking, van pool and mass transit benefits remains unchanged.
Qualified commuting and parking amounts provided to the employee by the employer in excess of the monthly statutory limits are subject to FICA, FUTA, FITW and SITW. For 2022, the statutory limits are $280 per month for qualified parking and $280 for transit passes and van pooling. An employee can be provided both benefits for a total of $560 per month, tax-free, with the excess included in Form W-2. Amounts exceeding the limits cannot be excluded as de minimis fringe benefits.
Caution: Mileage reimbursement to employees is not excludable as a qualified transportation fringe benefit and must be a working condition fringe benefit to avoid taxation.
For 2018 through 2025, bicycle commuting benefits that are qualified transportation fringe benefits are included in taxable wages subject to FIT, FITW, FITA and FUTA. Because these benefits are taxed to the employee as regular compensation, the benefits are deductible by the employer.
The value of any de minimis transportation benefit provided to an employee can be excluded from Form W-2. For example, an occasional taxi fare home for an employee working overtime or departing a business function such as a holiday party may be provided tax-free.
Please note that some local jurisdictions require employers to provide mass transit options. For instance, the District of Columbia requires employers with 20 or more employees to offer qualified transit benefits. While D.C. employers are not necessarily required to subsidize the cost of their employees’ commuting expenses under the new law, they are required to provide the option for employees to make a pre-tax election to take full advantage of the maximum statutory limits for transit, commuter highway or bicycling benefits. San Francisco and New York City have adopted similar laws in an attempt to promote the use of available mass transit options and to reduce automobile-related traffic and pollution. Employers should confirm that they are in compliance with local requirements regarding mass transit options for each employee location.
The value of the business use of an employer-provided cell phone (and other communications devices) provided primarily for noncompensatory business reasons is excludable from an employee's income as a working condition fringe benefit. If the cell phone, tablet or other device is provided to the employee as a “welcome aboard” or other bonus, and the item is not linked to the employer’s business, the fair market value of the item is treated as imputed taxable compensation to the employee.
Personal use of an employer-provided cell phone, given to the employee primarily for noncompensatory business reasons, is excludable from the employee's income as a de minimis fringe benefit. Employers provide a cell phone primarily for noncompensatory business purposes if there are substantial business reasons for providing the phone. Examples of substantial business reasons include the employer's need to contact the employee at any time for work-related emergencies, the requirement that the employee be available to speak with clients at times when the employee is away from the office and the need to speak with clients located in other time zones at times outside the employee's normal workday.
Employers cannot exclude from an employee's wages the value of a cell phone or tablet or other device provided to promote the goodwill of an employee, to attract a prospective employee or as a means of providing additional compensation to an employee.
Special Rules for Taxing Certain Employee Fringe Benefits to 2% S Corporation ShareholdersCertain otherwise excludable fringe benefit items are required to be included as taxable wages when provided to a 2% shareholder of an S corporation or of an LLC that elects to be taxed as an S corporation. A 2% shareholder is any person who owns, directly or indirectly, on any day during the taxable year, more than 2% of the outstanding stock or stock possessing more than 2% of the total combined voting power of the corporation. These fringe benefits are generally excluded from the income of other employees but are taxable to 2% S corporation shareholders similar to partners. If these fringe benefits are not included in the shareholder’s Form W-2, they are not deductible for tax purposes by the S corporation. The disallowed deduction creates a mismatch of benefits and expenses among shareholders, with some shareholders paying more tax than if the fringe benefits had been properly reported on Form W-2.
Taxable Fringe BenefitsThe following describes fringe benefits paid for by an S corporation that are includable in the 2% shareholder’s taxable income.
These fringe benefits are subject to FITW and SITW but not to FICA or FUTA. The amounts include premiums paid by the S corporation on behalf of a 2% shareholder, as well as amounts reimbursed by the S corporation for premiums paid directly by the shareholder. If the shareholder partially reimburses the S corporation for the premiums using post-tax payroll deductions, the net amount of premiums must be included in the shareholder’s compensation. Pre-tax payroll deductions cannot be used by 2% shareholders to reimburse premiums paid by the S corporation. However, 2% shareholders can deduct the premiums using the self-employed health insurance deduction in their personal federal income tax return (i.e., on Form 1040).
A 2% shareholder is not eligible to participate in a cafeteria plan created under IRC Section 125, nor can the shareholder’s spouse, child, grandchild or parent participate. If a 2% shareholder (or any other ineligible participant, such as a partner or nonemployee director) is allowed to participate in a cafeteria plan, the cafeteria plan will lose its tax-qualified status, and the benefits provided will therefore be taxable to all participating employees, nullifying any pre-tax salary reduction elections to obtain any benefits offered under the plan.
This fringe benefit is subject to FITW and SITW but not FICA or FUTA. If the shareholder partially reimburses the S corporation for the health plan contribution, using post-tax payroll deductions, the net amount of the contribution must be included in the shareholder’s compensation. Pre-tax payroll deductions cannot be used by 2% shareholders to reimburse plan contributions paid by the S corporation. However, 2% owners can take a corresponding self-employed deduction for the cost of their health savings account contributions on their Form 1040.
For 2% shareholders of an S corporation, employer-paid short- and long-term disability premiums are subject to FITW and SITW, but not to FICA or FUTA. Because the disability insurance premiums are paid with after-tax dollars, any disability insurance proceeds generally would be tax-free.
Group term life insurance premiums should be included in Boxes 1, 3 and 5 of a 2% shareholder’s Form W-2. The entire premium paid on behalf of a 2% shareholder under a group term life insurance policy is treated as taxable, not just the premium for coverage in excess of $50,000. Although the value is taxable income to the 2% shareholder, the cost of the insurance coverage (that is, the greater of the cost of the premiums or the Table I rates) is subject only to FICA tax withholding. The cost of the insurance coverage is not subject to FUTA, FITW or SITW. It should be noted that any life insurance coverage for which the corporation is both the owner and beneficiary (such as key man life insurance) does not meet the definition of group term life insurance and, therefore, there is no income inclusion in the shareholder’s Form W-2.
Employee achievement awards, qualified transportation fringe benefits, qualified adoption assistance, qualified moving expense reimbursements, personal use of employer-provided property or services and meals and lodging furnished for the convenience of the employer must be included as compensation when made available to 2% shareholders of an S corporation. All of the above fringe benefits are subject to FICA, FUTA, FITW and SITW.
The following fringe benefits are not includible in the compensation of 2% shareholders of an S corporation:
- Qualified retirement plan contributions
- Qualified educational assistance up to $5,250 (but tax-free benefits are not available if more than 5% of the educational assistance benefits are provided to 2% S corporation shareholders, their spouses or dependents)
- Qualified dependent care assistance up to $5,000 (but tax-free benefits are not available if more than 25% of benefits paid during the year are provided to individuals who own more than 5%)
- Qualified retirement planning services
- No-additional-cost services
- Qualified employee discounts
- Working condition fringe benefits
- De minimis fringe benefits
- On-premises athletic facilities