As 2021 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 2021, since COVID relief brought about a number of changes to the rules relating to traditional fringe benefits.
Fringe benefits are defined as a form of pay for performance of services a company gives 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, 2022 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.
Common Employee Fringe Benefits
Employer-Paid Group-Term Life Insurance Coverage
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.”
Employee Business Expense Reimbursements and Allowances
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.
COVID-19 “Qualified Disaster Payments” to Employees
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 Internal Revenue Code (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 lifted.
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 can 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 could pay for, reimburse or provide 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 health-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.
Employer-Paid Student Loan Debt
During 2021, employers could pay up to $5,250 of their employees’ student loan debt and not treat the payment as taxable wages. However, for these payments to be excluded from taxable wages, they must be made under a tuition assistance plan established under IRC Section 127 and meet 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)
This tax-free student loan debt repayment benefit was part of the 2020 CARES Act, and was originally scheduled to expire on December 31, 2020, but subsequent legislation extended it through December 31, 2025. Many employers are reevaluating the costs and benefits of this option for recruiting and retention.
PTO Leave Donation
Some employers allow employees to donate unused paid time off (PTO) to other employees who may need it. If handled incorrectly, both the donating employee and the recipient employee may have taxable income.
If the rules regarding paid leave donation programs are followed properly, then an employer would not include donated PTO in the donor’s Form W-2, but it is included in the recipient employee’s Form W-2.
The number of PTO donation programs has increased in 2021 because of COVID-19’s widespread effect on where employees work and their decisions to take planned time off or not. Reports indicate that about half of American workers switched to working from home rather than in an office and many have canceled or cut back on vacation plans, doctors’ appointments and planned medical procedures. As a result of being home more and taking fewer planned days off from work, many employees have not used their accrued PTO.
Employers can set up leave-sharing plans that allow employees to surrender accrued PTO for the benefit of other employees dealing with medical emergencies (including death or other hardships caused by a federally declared “major disaster,” including COVID-19). Under long-standing IRS guidance, employees who donate leave to other employees for such hardships through an employer leave-sharing plan may exclude the value of the leave from their income, provided the value is included in the recipient employee’s income. Under the IRS guidance, employees are adversely affected by a major disaster if it has caused severe hardship to the employee (or to a family member) that requires the employee to miss work.
Employers must administer the leave-sharing program pursuant to a written plan that specifies that leave is to be used only for medical emergencies, death of a spouse, child or parent, or hardship due to a major disaster. The plan 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). Donated leave goes into a commingled pool and donors cannot specify who will receive their donated leave. 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 2020-46 provides that cash payments employers make to charities that provide relief to COVID victims in exchange for employees forgoing PTO are not taxable wages for the donor-employees. Donor-employees cannot claim a charitable deduction for the donated leave. Employers may deduct these cash payments as a business expense or as a charitable contribution deduction if the employer otherwise meets those requirements. Recipients must be charitable organizations, including national, regional and faith-based organizations that are assisting victims of the COVID-19 pandemic.
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.
Following the declaration of COVID-19 as a national disaster on March 13, 2020, many employees ceased using company cars for business during 2020, but nevertheless kept the company car. Under IRS rules, generally, all use of a company car is considered personal use unless the employee documents the business use of the car. As a result, many employees may have been surprised by the amount of imputed income reported on their 2020 Form W-2 attributed to their possession of a company car. To help address this situation, on January 5, 2021, the IRS issued Notice 2021-7 announcing that employers could switch from using the “vehicle lease” valuation method to the “cents-per-mile” method (57.5 cents per mile for 2020 and 56 cents per mile for 2021) for determining the employee’s personal use of the company car after March 13, 2020. Generally, IRS rules prohibit switching valuation methods, but using this relief could result in substantial tax savings. Another option to avoid unwanted imputed income for personal use of a company car would be for the employee to simply return the company car.
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 withholdings.
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.
Reports indicate that both personal and business use of company aircraft has increased in 2021 because of COVID-19, so employers may need to address this issue for 2021, even if they have not encountered it in past years.
Benefits That Exceed the 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. A common misconception is that if a fringe benefit is 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 ham, 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 and entertainment is limited to 50% of food and beverage expense excludable under the de minimis fringe benefit rule and quiet business meals with customers and clients (i.e., no entertainment is involved). 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 only deductible for the employer up to $25 per person per year, unless the excess is included as taxable compensation for the recipient. Any gifts in excess of $25 per person per year to employees 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).
Job-Related Moving Expenses Paid by Employer
Moving expenses incurred during 2021 that are paid for 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.
Qualified Transportation Fringe Benefits
Employers cannot deduct expenses incurred in providing any 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 2021, the statutory limits are $270 per month for qualified parking and $270 for transit passes and van pooling. An employee can be provided both benefits for a total of $540 per month, tax-free, with the excess included in Form W-2. Amounts exceeding the limits cannot be excluded as de minimis fringe benefits.
Bicycle commuting benefits incurred on or after January 1, 2018, 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.
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 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. 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 Benefits
The following describes fringe benefits paid for by an S corporation that are includable in the 2% shareholder’s taxable income.
Health, Dental, Vision, Hospital and Accidental Death Dismemberment Insurance Premiums and Qualified Long-Term Care (LTC) Insurance Premiums Paid Under a Corporate Plan
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 their personal federal income tax return (i.e., on Form 1040).
Cafeteria Plans
A 2% shareholder is not eligible to participate in a cafeteria plan created under IRC Section 125, nor can the shareholders’ 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 pretax salary reduction elections to obtain any benefits offered under the plan.
Employer Contributions to Health Savings Accounts and Other Tax-Favored Health Plans
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.
Short-Term and Long-Term Disability Premiums
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 Coverage
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.
Other Taxable Fringe Benefits
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.
Nontaxable Fringe Benefits
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