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Benefit Plans: Tax Considerations - March 2017
Employee benefits can be complex to administer, particularly
in terms of taxation. It is important to understand the tax implications for
both the employer and employee. This article will explain the general
considerations related to the taxation of employee benefits.
Employers can usually deduct amounts that they spend on
employee benefits as a trade or business expense when filing taxes. In order to
be deductible as a trade or business expense, the expense must meet the
- It is an ordinary and necessary expense of the
employer’s trade or business.
- The IRS
defines “ordinary” as common and accepted in your trade or business. A
“necessary” expense is one that is helpful and appropriate for your business;
it need not be indispensable to be considered necessary.
- The expense must be paid or incurred during the
tax year in which it is deducted.
depends on whether your company uses a cash method or accrual method of
accounting. If using a cash method, the expense is deductible in the year it is
paid. If accrual method is used, the expense is deductible in the year it is
- The expense must be connected with the trade or
business conducted by the taxpayer (employer).
requirement simply differentiates a business with a primary purpose of
achieving income or profit from a sporadic hobby or activity that happens to
It is also important to remember for noncash benefits that
the employer may deduct only the cost of the benefit (though the value of the
benefit must be included in the employee’s gross income).
Employee Tax Implications
The employer is also responsible for determining if various
benefits should be included in the employees’ gross income for tax purposes.
Generally, a benefit must be included in the employee’s taxable income unless
specifically excluded by the IRS. Many employee benefits are expressly excluded
from gross income by the IRS, including health insurance, life insurance (up to
a limit), education assistance, flexible spending accounts, child care
expenses, legal assistance and more. Visit www.irs.gov for a complete list. In
addition, some benefits are tax-deferred until the employee receives the
benefit, such as qualified retirement benefits.
For benefits that are taxable, you must answer the following
questions to determine the appropriate tax treatment of that particular
- Who is
subject to the tax? Even if the benefit applies to someone else (like
educational expenses for a child or a benefit for a spouse), the employee is
generally the one who should be taxed.
- When is
the benefit taxable? Generally, the benefit counts as income when the
benefit is actually received. One exception is the “constructive receipt” of a
benefit (when the employee is legally entitled to a benefit, even if it is not
in his or her possession). One example is funds in an account that are
available to the employee at any time; these would be taxed once they become
available, even if the employee hasn’t spent them.
- How much
of the benefit is taxed? For noncash benefits, the value of the benefit is
more important than the actual cost to the employer. The value of a benefit is
determined by the “fair market value,” not including any amount that the
employee had to contribute or any amount specifically excluded by a provision
of the law. Fair market value is the amount a hypothetical person would pay an
objective third-party for that particular benefit.
Benefits that are not included in taxable income are also
likely excludable from Social Security, Medicare and unemployment insurance
taxes. The employer, however, does need to consider any special rules, such as
nondiscrimination rules, to be met for certain employees. Also, some benefits
only allow a certain portion to be non-taxable; the employer should be aware of