Is That Payment Taxable? 5 Key Tax Facts All Employers Should Know
By Procopio Partner Eric D. Swenson
There is no end to the creativity employers bring to the task of providing benefits and rewards to current and former employees, and that creative thinking is often applied with the intent of reducing or avoiding tax liability to the employee. Whether it is a carefully crafted severance agreement (great idea!!), a convoluted deferred compensation plan, or a purported gift program, new tricks are tried every day. After twenty years in private practice following practicing more than several years as an IRS attorney, I keep thinking that I have seen it all, and then I am once again proven wrong.
What is often overlooked by employers, but must always be remembered, is that generally any “accretion” to wealth (whether by way of the receipt of a payment or other benefit) is deemed taxable income, unless a specific legal exemption exists. In my experience, there are at least five areas involving payments or other benefits offered to current or former employees where this rule of thumb applies, and not fully understanding this general rule can lead to violations of the law and potentially significant penalties for employers and employees alike.
1. Fringe benefits
There are taxable and nontaxable fringe benefits. So what is a fringe benefit? Consider this scenario: A few minutes before I leave work for the day, I use my desk phone to call my wife and ask her again what I need to pick up at the store on the way home. I write that list down on a sheet of paper from the firm provided legal pad, and staple (with a firm issued stapler) that inside my day planner. All three of those personal activities comes at a cost to the employer. Is the accretion of wealth I received in the form of a sheet of paper, a staple, and a few minutes of telephone use taxable to me?
Fortunately, the answer is no, because they are what the IRS considers de minimis (i.e., trivial). But it is important to understand there is no bright line rule on what is considered de minimis. The IRS has decided, however, that if you give an employee a turkey at Thanksgiving, that gift is not taxable, as the cost is generally under $25 and thus de minimis. However, if you give that same employee a $25 gift card to a local coffee shop, that is considered a cash gift that should be treated as taxable wages regardless of the amount.
More specifically, the exception in the tax law provides that the de minimis fringe benefit exclusion applies if: 1) an item is small in value; 2) the item is infrequently provided; and 3) it is administratively impracticable for the employer to account for. That being said, cash gifts are never excludable as de minimis and a gift card (for example to Starbucks) is deemed a cash equivalent and therefore taxable, no matter the amount.
What about benefits that are not de minimis? Remember the famous Oprah Winfrey “You get a car! You get a car!” episode? Well, each audience member receiving a free car also owed the IRS tax on that wealth accrual totaling several thousand dollars (prizes are taxable). One way you as an employer can make it easier on the employee gift recipient, is what Oprah Winfrey apparently did for the audience members, is to “gross up” the gift. Instead of, say, giving the employee a $100 holiday bonus, you could give him or her $100 plus the expected tax due on that amount so that after taxes, or when the dust settles, the employee has received exactly a $100 after-tax gift.
A tricky area of the law is the reimbursement to employees for educational expenses. Given the increasing cost of tuition, this can be an enticing benefit to offer employees. As a general rule, if an employee is incurring expenses for professional training that will make him or her perform better or even take on more responsibility on the current job, you can reimburse the employee for that expense without that payment being taxable. There are exceptions, however. If you encourage a mid-level marketing executive in your company to enroll in a Masters’ in Business Administration program and offer to pay the tuition, the IRS will likely consider that a taxable fringe benefit. If the study will make her a better employee, you might ask, why is it taxable? Because it could lead to her pursuing a new career with that degree in hand. Were she to take the courses but not earn credit toward a degree, that “might” be a different matter, but that is not the general rule. If properly documented, IRC Section 127 (and a Section 127 Plan) does allow, however, up to $5,250 of an employee’s gross income each calendar year to be excluded from taxes for the purpose of educational assistance. A Section 127 Plan takes almost all of the guess work out of determining whether the education would lead to a new career or not as it is applicable to almost any type or form of education.
What about payments to an employee that are actually reimbursements? Let’s say you ask an employee to attend a work-related event. He has to pay $10 to park, and asks you to reimburse him, which you happily do. Is that accrual of $10 in wealth considered taxable?
First, you need to understand that under the recently enacted tax law, the Tax Cuts and Jobs Act of 2017, an employee is no longer able to deduct certain unreimbursed employee business expenses on their own individual income tax return. As a consequence, obtaining a tax-free reimbursement from their employer is even more important than ever. Consequently, an employer should make it possible for the employee to be reimbursed tax-free.
Back to the example, the $10 reimbursement may be taxable to the employee (for which he will not be able to make a corresponding deduction on his own individual income tax return) if you the employer do not have an “accountable plan” in place, and even if the expense were 100% business related. As an employer, you should have a policy that is clear to all employees as to expenses that are reimbursable and what process or procedure the employee is supposed to follow in order to get reimbursed. This typically includes a requirement of timeliness of submission for reimbursement, as well as the stated business purpose and proper substantiation. If you have an accountable plan but it is not currently in writing, you will want to get it memorialized in writing now. Otherwise, such legitimate reimbursements of business expenses will be 100% taxable to the employee (with no possible offset/deduction) under the new tax law which is effective in 2018.
3. Deferred compensation
There are plenty of reasons why you as an employer may wish to defer certain payments to an employee. Perhaps you are dangling a big bonus to lure a top new executive recruit, but your budget can only accommodate the payment if you stretch it out over multiple fiscal years. Or, perhaps, the employee wants to be taxed in a later tax year. You might wish to do the same for a large severance payment. Both you the employer and the recipient of the funds may believe the general rule that taxes would not be due on those payments until they are actually made.
That might not be the case. As it happens, the Internal Revenue Service has very complex and at times counterintuitive rules on deferred compensation, found in among other places at Internal Revenue Code Section 409A. If certain filing deadlines are not met, and payments are not linked to certain payment triggers, or are subject to change in the dates of payment, the plan may not meet IRS approval. Taxes would be due at the time of the deferral agreement, instead of when received. If your plan does not comply with Section 409A, the employee could be subject to both immediate taxation and a 20% federal penalty, with California workers facing an additional 5% penalty. As a rule of thumb, if pursuant to an agreement any payment, including severance pay, extends into a future tax year, you should confirm that such payment is in compliance with IRC 409A.
4. Severance pay
Speaking of severance pay, let us look a bit more closely at how such payments are to be taxed, and what employers are expected to do regarding those taxes. If both parties agree that any post-employment payments made are considered severance pay wages, then the employer simply does the standard tax withholding and reports the payment on the W-2 issued to the former employee. Things get complicated, however, when we are talking about various payments made in a legal settlement.
In a separation negotiation, the employee often pushes to have as much of the payment as possible not considered compensation (i.e., wages), so that such amounts are not deemed wages subject to (i) various payroll taxes; and (ii) income tax and payroll tax withholding that must be made by the ex-employer at the time of the payment. The portion of the total separation payment that is not deemed “wages” is any amount properly allocated to non-wage claims such as attorney fees, penalties, emotional distress, etc. The portion of the separation payment allocated to the non-wage claims are not reported on a FormW-2, but instead on a Form1099.
The tax law also allows certain forms of severance to be completely exempt from taxes. Take, for example, an employee who is driving his vehicle to work and is hit by another car driven by a negligent driver. Every expense stemming from (and on account of) that personal physical injury—damage to the vehicle, medical bills, emotional distress, and even lost wages—is excludable from income tax. Should a departing employee seek compensation for costs he or she claims is work-related—high-blood pressure medication or psychiatric bills—but they do not stem from a personal physical injury, those payments by the employer would still be taxable. It is not entirely uncommon for a plaintiff seeking severance from an employer to at some point in the case lay claim to a recent or previously unreported workplace injury in order to tie sought reimbursement to a personal physical injury and thus avoid tax liability. Employers should keep clear records and understand the ramifications, both tax and labor law ramifications, when settling cases involving alleged physical injuries. Allocating a settlement among different (and substantiated) types of claims can benefit both the employee/plaintiff and employer/defendant.
5. Employee loans
So if deferred compensation and settlement payments are taxable, are loans from an employer to an employee? Often, yes, with the taxes due upon receipt of the loan. Let’s say you decide, in lieu of offering that new executive recruit a large signing bonus, instead offer a loan with promise of forgiveness. Perhaps it is for $200,000, with 25 percent of it forgiven at the end of each year, so that if the new hire stays with your company for four years, you will have completely forgiven the loan. You might think a loan is not taxable, but remember, this is another form of accretion of wealth. When that first $50,000 of the loan is forgiven at the end of the first year, the employee is in their personal ledger now $50,000 richer. There is $50,000 of deemed wages received at that time. In many cases, however, the IRS would argue that the compensation even occurred when the employee first received the $200,000, and it is that upfront payment that is taxable at the time of initial receipt.
Is there a way for you to loan money to an employee without it being taxed? Yes, if you can document it as a truly bona fide loan. That means generally the loan has all of the traditional trappings of a loan, such as regular payments, an interest rate, penalties for nonpayment, etc. Too often, however, I have seen employee loans that were considered taxable upon receipt by the IRS. There is a recent Tax Court case where the court agreed with the IRS. In short, obtain proper tax guidance if you make an employee a loan, especially a loan that is to be satisfied by way of future services.
Again, remember that any accretion of wealth is taxable unless there is a specific legal exemption. By now you can see that there are some parameters within which you can stay compliant with the law while offering creative forms of compensation to your employees. With this guidance in mind and proper legal counsel, you can stay on the right side of the IRS. Who would not want that?
Eric D. Swenson is a Partner at Procopio and a member of the Tax Practice Group. Eric’s practice focuses on tax controversy and business transactions. He is a former IRS attorney who represents corporations, partnerships, nonprofits and individuals in federal, state and local tax disputes involving audits, appeals and litigation before several tax agencies. He works with Procopio’s Labor and Employment Practice Group in advising employers on a wide variety of tax-related matters.