2023 Year-End Reminders Regarding Common Fringe Benefits, Special Rules for 2% S Corp Shareholders
2023 Year-End Reminders Regarding Common Fringe Benefits, Special Rules for 2% S Corp Shareholders
As 2023 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 2023 and beyond, as many employers continue to deal with remote or hybrid workforces.
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, 2024, may result in penalties. Employers have the burden of proving that tax-free treatment of fringe benefits was appropriate.
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.
Remote Workforce Fringe Benefits
Many businesses now allow employees significant flexibility in choosing their work location. A common work arrangement allows an employee to regularly work from their personal residence 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 personal residence 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. Also, any commuting expense paid by the employer is nondeductible even when included as taxable compensation to the employee. Commuting expenses that qualify as tax-free under IRC 132 but are in excess of the annual limits are excepted from the provision and are deductible if taxed to the employee. 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 expenses incurred while working from home. 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).
To constitute a business expense, the employee’s home workspace 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 in-office meals tax-free to employees during meetings or when they are working on pressing projects. In addition, many employers provide tax-free snacks and beverages in an office break room. Some employers want to continue to provide such tax-free meals or snacks to remote employees who generally work from their personal residence. 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 personal residence when called to the office might not qualify for treatment as tax-free meals while away from their 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 premiums. 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 their personal residence 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.
Employer-Paid Educational Assistance
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); and
- Employers cannot give employees a choice between educational assistance and other compensation.
COVID-19 relief legislation expanded IRC Section 127 tax-free benefits to include student loan debt repayments, but that provision is scheduled to expire on December 31, 2025. The student loan debt must be for the employee’s own education (in other words, student loan debt payments cannot be made toward the education of an employee’s spouse or child).
In order to recruit new employees and hopefully create loyalty that improves retention, businesses are increasingly interested in paying for education expenses of 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.
PTO Leave Donation
Many people are now working from their personal residence and have greater flexibility to spend time on personal matters without being charged for paid time off (PTO). Even routine doctor visits require less time off due to the widespread availability of virtual, on-line services. At 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 for medical emergencies (including extended time off due to the death of a spouse, child, or parent), for federally declared disasters, or for both (although 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 generally cannot specify who will receive their donated leave. Typically, 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 2023-69 provides that cash payments employers make to charitable organizations during 2023 and 2024 providing relief to victims of the wildfires in Maui, Hawaii that began on August 8, 2023, in exchange for forgone PTO will not be treated as compensation to the donating employees. Donor-employees cannot claim a charitable deduction for the donated leave. But employers could deduct these cash payments either as a business expense or as a charitable contribution deduction if the employer otherwise met those requirements. Recipients have to be charitable organizations, including national, regional, and faith-based organizations that assisted wildfire victims. Contributions cannot be made to individuals directly. Periodically, the IRS announces that certain disasters or emergencies qualify for this special tax treatment. For example, IRS Notice 2022-28 allowed similar relief for employee leave donations made by an employer during 2022 to charities that aid victims of the Russian invasion of Ukraine.
Personal Use of Company Car
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 employees for the business use of their 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.
Personal Use of Company Aircraft
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.
Benefits That Exceed De Minimis Exclusion
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. That special rule was not available in 2023 and beyond. 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.
Employee Achievement Awards, Gifts and Prizes
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 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).
Job-Related Moving Expenses Paid by Employer
Moving expenses incurred during 2023 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, due to the changes in the law made by the Tax Cuts and Jobs Act (TCJA) of 2017.
Qualified Transportation Fringe Benefits
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. The 2020 final regulations on how to calculate the disallowed deduction for employee qualified transportation costs include some helpful 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 2023, the statutory limits are $300 per month for qualified parking and $300 for transit passes and van pooling. An employee can be provided both benefits for a total of $600 per month, tax-free, with the excess included in Form W-2. For 2024, the limits increase to $315 (for a combined maximum total of $630). 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 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.
Noncompensatory Cell Phones (and Other Devices)
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 Shareholders
Certain 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 the way they are taxed if received by 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 Benefits
The 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 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