Sec 3: Taxable and Nontaxable Compensation Flashcards
Gross Income and Wages Under the IRC
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Gross Income
The IRC uses the term “gross income” as the starting point for determining a taxpayer’s federal tax bill, and in it broadly defines the term as including “compensation for services, including fees, commissions, fringe benefits, and similar items
Wages and Benefits
What this means is that wages and benefits (whether they are called fringe benefits or “perks” or something else) are generally included in income and subject to income and employment tax withholding, deposit, and reporting requirements unless the IRC says otherwise. The Code does not define the term “fringe benefit,” though the Code
and the IRS Regulations include several examples of both included and excluded fringe benefits:
Examples
- Employer- provided cars
- Flights on employer- provided aircraft
- Free or discounted commercial flights
- Vacations
- Discounts on property or services
- Employer- paid memberships in country clubs or other social clubs
- Tickets to entertainment or sporting events
- Qualified tuition reductions
- Dependent care assistance
- No- additional- cost services
- Working condition fringes
- Qualified transportation fringes
- De minimis fringes
Income and Employment Taxes Defined
In general, when employee compensation is described as “taxable,” this means:
* It is subject to federal income tax and the employer must withhold the tax from the employee’s pay and remit it to the Internal Revenue Service.
* It is subject to social security and Medicare taxes under the Federal Insurance Contributions Act (FICA), as well as federal unemployment tax under the Federal Unemployment Tax Act (FUTA)— these taxes are often referred to as employment taxes.
Fair Market Value
When noncash fringe benefits or “perks” are provided by an employer to its employees, the amount of the benefit is defined as its fair market value, or what it would cost an individual to purchase the benefit on the open market in an “arm’s length transaction
IFBA = FMV – (EPA + AEL)
IFBA = Includable Fringe Benefit Amount
FMV = Fair Market Value
EPA = Employee- Paid Amount (with after- tax dollars)
AEL = Amount Excluded by Law
Example 1: Harry’s employer pays for Harry’s parking space in a commercial parking lot next to the employ- er’s premises. The employer’s cost for the space is $350 per month in 2024, which is the same fee charged to all monthly payers. Harry pays nothing for the parking space and has access to it every day. Up to $315 per month of employer-provided parking is excluded from income by law in 2024 (see Section 3.2-1). Harry’s taxable income from the parking benefit is determined as follows:
IFBA = $350 – ($0 + $315)
IFBA = $350 – $315
IFBA = $35 per month
Nontaxable Fringe Benefits
- No-additional-cost services
- Qualified employee discounts
- Working condition fringes
- De minimis fringes
- Qualified transportation benefits
- On-premises athletic facilities
- Qualified retirement planning services
No‑additional‑cost services
No‑additional‑cost services. An employer may offer free services to its employees without including the fair market value of those services in the employees’ income if the following conditions are met:
- The free service is one that is regularly offered for sale to customers (not employees) in the normal course of the employer’s “line of business” in which the employee works. There is an exception where companies have written “reciprocal agreements” providing free services to employees of the other employer covered by the agreement and neither employer incurs substantial additional cost in providing the benefit.
- The employer bears no substantial additional cost (including lost revenue and additional labor) in provid- ing the service to the employee.
- The term employee includes current and former employees who left because of retirement or disability and their widow(er)s, spouses, and dependent children. For the purposes of air transportation, the term employee also includes a parent of an employee.
- The service is available on equal terms to each member of a group of employees whose classification does not discriminate in favor of highly compensated employees.
Qualified employee discounts
n employer may offer discounted goods or services to its employees without
adding the fair market value of the discounts to the employees’ income if the following conditions are met:
- The discount on goods cannot exceed the gross profit percentage when the goods are sold to customers (not employees). The gross profit percentage is: (total sales – cost of goods sold) ÷ total sales
- The discount on services cannot exceed 20% of the price at which the services are offered to customers. If the discount exceeds 20%, the excess is taxable income to the employee.
- The goods or services must be offered for sale to customers in the employer’s line of business in which the employee normally works.
- The discount is available on equal terms to each member of a group of employees whose classification does not discriminate in favor of highly compensated employees (for a definition, see the discussion earlier in this section on no-additional-cost fringes).
- Real estate, whether for investment purposes or not, does not qualify for the employee discount. Neither does personal property normally held for investment, such as stocks, bonds, or currency.
- The term employee includes current and former employees who left because of retirement or disability and their widow(er)s, spouses, and dependent children.
Working condition fringes
Working condition fringes. An employer may offer certain work-related property or services to employees without including their fair market value in the employees’ income if the following conditions are met:
- The employee’s use of the property or services must relate to the employer’s trade or business.
- The employee would be able to take a business deduction on his or her personal tax return if the employee paid for the benefit (but see exception for reimbursements of business-related club dues and spousal travel expenses).
- The term “employee” means a current employee, partner, director, or independent contractor performing services for the employer.
- The employer must maintain the required records to substantiate the business deductions. Where the benefit is in the form of cash, the employer must require beforehand that the payment be used for a business activity, that the employee verify that the payment was used for that purpose, and that any excess be returned to the employer within a reasonable period of time.
De minimis fringes
De minimis fringes. An employer may provide certain property or services of small value to employees without including the value in the employees’ income if the following conditions are met:
- The value of the benefit is so small that accounting for it would be unreasonable or impracticable.
- The employer must take into account the frequency with which it provides the benefit to all its employees in making this determination.
- The term employee means anyone to whom the benefit is provided.
Qualified transportation fringes
Qualified transportation fringes. An employer may provide certain transportation fringe benefits to its employees without including the fair market value of the benefits in their income. They include:
- Transportation between home and work in a commuter highway vehicle provided by the employer (e.g., vanpool) if:
* The vehicle seats at least 6 adults other than the driver
* At least 80% of the vehicle’s mileage can be expected to be for commuting
* At least one-half of the vehicle’s seating capacity (excluding the driver) is used by employees
The excluded benefit is limited to a value of $315 per month in 2024.
- Transit passes, vouchers, tokens, or fare cards, or reimbursement for them by the employer, for up to $315 per month in 2024.
- Parking provided on or near the employer’s premises or at a “park and ride” facility from which the employee uses mass transportation, a vanpool, or a carpool or any other means to get to work, up to a value of $315 per month in 2024. Parking “on or near the employer’s premises” includes parking on or near a work location where the employee works for the employer, but not if the value of parking provided by the employer or reimbursement for the employee’s parking cost is otherwise excluded from income as a working condition fringe benefit or an employee business expense reimbursed under an accountable plan.
On‑ premises athletic facilities
On‑premises athletic facilities. An employer may allow its employees to use an on-premises gym or other athletic facility free of charge without including the fair market value of the use in the employees’ income if the following conditions are met:
- The athletic facility is located on the employer’s premises, whether leased or owned by the employer.
- The athletic facility is operated by the employer through its employees or another entity.
- Substantially all use of the athletic facility is by employees, their spouses, and their dependent children.
The term employee includes current and former employees who left because of retirement or disability, as well as their widow(er)s. - The athletic facility is not a resort or other residential facility.
Qualified retirement planning services
Employers can provide retirement planning services to their employees and the employees’ spouses without the value of the services being included in the employees’ income or subject
to social security, Medicare, or FUTA tax.Qualified retirement planning services include retirement planning
advice or information provided by an employer maintaining a qualified retirement plan— a §401(a), §401(k),
§403(b), simplified employee pension (SEP), §408(p) SIMPLE, or §501(c)(18)(D) plan, but not a §457 plan
Personal Use of Employer‑ Provided Vehicles
When the vehicle is used for business- related purposes, the value of the use is excluded from income as a working condition fringe benefit. All other use of the vehicle is generally considered taxable income to the employee— unless an exception applies
There are several exceptions to the personal use rule. They are:
De minimis fringe benefit. If the employee uses a company car mainly for the employer’s business, infrequent and brief side trips for personal reasons are considered de minimis fringe benefits whose value is excluded from income.
Qualified nonpersonal use vehicle. If a company-provided vehicle is unlikely to be used for personal travel because of its special design, use of the vehicle by an employee is excluded from income. Such vehicles include:
- Marked police, fire, and public safety officer vehicles
- Unmarked vehicles used by law enforcement officers if the use is officially authorized
- Ambulances or hearses
- Delivery trucks with only a driver’s seat
- Moving vans
- School buses
- Passenger buses seating at least 20
- Animal control vehicles
- Dump trucks
- Refrigerated trucks
- Qualified utility repair vehicles
- Trucks with a loaded weight of over 14,000 pounds59
Automobile salespeople. Use of a demonstration vehicle by a full-time automobile salesperson or sales manager within the sales area of the dealership is excluded from income as a working condition fringe benefit if the personal use of the vehicle is substantially restricted (e.g., no one else can use the vehicle, no vacation trips, no storage of personal possessions).60 To qualify for the exclusion, managers must manage the sales staff rather than parts
The employer must maintain the following records to satisfy the requirements for the full exclusion for any month:
- A copy of the written policy on vehicle use and evidence that it was communicated to the employee (e.g.,
a copy of a poster, letter, or electronic communication notifying the employee of the policy, or a statement signed by the employee acknowledging receipt of the written policy) - Records establishing that the salesperson’s personal use (by mileage) was calculated at least once each calendar month, including the following:
— Records identifying each demonstration automobile assigned to each salesperson during the period
— Records identifying the total mileage for each demonstration automobile assigned to a salesperson during the period
— Records supporting the total use outside of normal working hours under the “simplified out/in method” for each day the automobile is used (i.e., records showing the “out mileage” on the automo- bile at the end of the working hours of the salesperson using the automobile and the “in mileage” at the beginning of that salesperson’s working hours on the next working day)
— Records identifying the round trip commuting mileage of each salesperson assigned a demonstration automobile from the salesperson’s home to the dealer’s office during the period.
Simplified method for partial exclusion
Simplified method for partial exclusion. Where a full-time salesperson (otherwise satisfying the requirements for the full exclusion) exceeds the average 10 miles per day of personal use or does not provide records with respect to the business use of a demonstration automobile, the employer will generally be able to account for the use of the vehicle by using the simplified partial exclusion method. In order to use this method, the following conditions must be met:
- The employer must have a written policy limiting the use of the demonstration automobile that prohibits use of the vehicle outside of normal business hours by individuals other than full-time salespeople, prohibits use of the vehicle for personal vacation trips, and prohibits storage of personal possessions in the vehicle.
- The employer must reasonably believe that the full-time automobile salesperson has complied with that policy.
- The employer must account for the nondeductible personal use of any full-time automobile salesperson by including in the employee’s gross income at least monthly the appropriate amount from the table below and must maintain records necessary to support that accounting, namely records supporting the
determination of the value of the use of the demonstration automobiles. The employer must also maintain records showing that appropriate amounts were timely included in an employee’s wages (e.g., copies of wage statements). Finally, the employer must maintain a copy of its written policy on demonstration automobile use and evidence that the policy was communicated to the employee (see earlier discussion).
Inclusion of the value when no exclusion applies
See 3-20
Accounting for vehicle use
Accounting for vehicle use. If an employee uses a company-provided vehicle for both business and personal travel, the employee must account to the employer for the business use. This is done by substantiating the usage (e.g., mileage), the time and place of the travel, and the business purpose of the travel. Written records made at the time of each business use are the best evidence. Any use of a company-provided vehicle that is not substantiated as business use is defined by the IRC to be personal use and is included in income.
Another option for employers is to treat all employee use of a company-provided car as personal use by including the value of all use in the employee’s income. Employers doing this risk overpaying social security, Medicare, and FUTA taxes, however, if some of the vehicle use was nontaxable and the employee’s income does not exceed the social security or FUTA wage bases.
Valuation methods
Valuation methods. Employers can determine the fair market value of taxable personal use of a company- provided vehicle by using either a general valuation method or one of three special valuation (i.e., safe-harbor) methods.
General valuation method
Under the general valuation method, the fair market value of a company- provided vehicle is the price an individual would pay to lease the same or a comparable vehicle in an arm’s length transaction in the same geographic area for the same length of time. A cents- per- mile lease rate cannot be used unless it can be
shown such a lease was available for that type of car at that time and in that area. Because an employee’s use of the
vehicle is generally mixed between business and personal use, it is most likely more advantageous to use one of the
special valuation methods.
Special valuation methods
There are three special valuation methods for determining the fair market value of the personal use of a company- provided vehicle: commuting valuation; vehicle cents- per- mile valuation; and annual
lease valuation. Here are some general rules that apply:
- If either the vehicle cents-per-mile or annual lease valuation method is used by the employer, it must be used for all subsequent years that the vehicle is provided to any employee, although the employer may switch to the commuting valuation method in any year it applies.
- Neither the employer nor the employee may use a special valuation method unless at least one of the fol- lowing is met:
a. the employer reports the value of the benefit as wages by January 31 of the next year b. the employee includes the value of the benefit in income within the prescribed time
c. the employee is not a control employee (see the discussion of the commuting valuation method following)
d. the employer demonstrates a good faith effort to treat the benefit correctly for reporting purposes - The same special valuation method need not be used for all company-provided vehicles or all employees.
- If an employer uses a special valuation method, the employee must use the same rule or the general valua- tion method on his or her personal income tax return.
- If a single company-provided vehicle is used by more than one employee, the employer must use the same special valuation method for all the employees using that vehicle and must allocate the vehicle’s use based on the facts of the situation.
Commuting valuation method
Commuting valuation method.66 This method allows an employer to value an employee’s personal commuting use of an employer-provided vehicle at $1.50 per one-way commute and $3.00 per round trip if the following conditions are met:
- The vehicle is owned or leased by the employer and is provided to the employee for use in connection with the employer’s trade or business.
- The employer, for noncompensatory business reasons, requires the employee to commute to and/or from work in the vehicle.
- The employer has a written policy prohibiting the employee (and the employee’s spouse and dependents) from using the vehicle for personal use other than commuting or de minimis personal errands, and the policy is enforced.
- The employee is not a control employee. In the private sector, a control employee is an employee who:
- Is a corporate officer earning at least $135,000 in 2024 (indexed annually to the next lowest multiple of
$5,000) - Is a director
- Earns at least $275,000 in 2024 (indexed annually to the next lowest multiple of $5,000)
- Is a 1% owner
In the public sector, a control employee is an employee who: - Is an elected official or
- Earns more than a federal employee at Executive Level V ($180,000 in 2024).
Annual lease valuation method
Under this method, the fair market value of an employee’s personal use of acompany- provided car is determined by multiplying the annual lease value of the car (as found in Table 3.1
following) by the percentage of personal miles driven. Here are the steps the employer must take:
1. The employer must determine the fair market value of the car as of the first day it was made available to any employee for personal use. For employer-owned vehicles, this is the total cost of the car to an individual in an arm’s length transaction (including sales tax and title fees.) For employer-leased vehicles, the value can be determined by using a nationally recognized pricing source, such as the “blue book.” Whether the car is owned or leased by the employer, its value must be recalculated after four full calendar years. If the vehicle is transferred to another employee, the annual lease value may be recalculated based on thecar’s fair market value on January 1 of the calendar year of the transfer.
2. Find the car’s fair market value in the Table 3.1
3. Calculate the percentage of personal miles driven during the year (personal miles driven ÷ total miles driven).
4. Calculate the fair market value of the employee’s personal use of the car that must be included in the
employee’s income (annual lease value x percentage of personal miles driven).
Company fleet valuation
Company fleet valuation. Where a company has a fleet of at least 20 vehicles, it may use the average fair market value of the vehicles to determine their annual lease value. There are certain limitations, including recalculating the value at least once every two years. Also, the fair market value of any of the vehicles in the fleet may not exceed a certain amount on the day the vehicle is first provided for use by the employee. For 2024, the maximum value for all vehicles is $62,000. This amount is indexed annually for inflation.
Vehicle cents‑per‑mile method
Vehicle cents‑per‑mile method. Under this method, the fair market value of an employee’s personal use of a company-provided vehicle is determined by multiplying the IRS’s business standard mileage rate by the number of personal miles driven. The business standard mileage rate for 2024 is $0.67 (67 cents) per mile (indexed annually). To use this method for standard passenger automobiles, the following conditions must be met:
- The employer must expect the employee to regularly use the vehicle while conducting the employer’s business, or the vehicle must actually be driven at least 10,000 miles annually (including personal use) and be used primarily by employees.
- The fair market value of the car cannot exceed $62,000 for cars placed in service in 2024 (indexed annually). The maximum values of cars placed in service in earlier years are (see chart)
- If the employee pays for fuel, the mileage rate is reduced by 5.5 cents ($.055) per mile for 2024 (indexed periodically).
Recordkeeping
The employee should log the business use of the vehicle
for each trip including the date, business purpose of the trip, and mileage. However, if the employee’s business or personal mileage is the same for each period during a year (e.g., each week, month, etc.), adequate records kept during one period can be used to project totals for the entire year. An employer can avoid these substantiation requirements by enforcing a written policy
Life Insurance
One of the more popular benefits offered employees is employer- provided life insurance. The most common type of insurance is group- term life insurance, which most often provides a death benefit payable in a lump sum to the employee’s designated beneficiary. Special rules in the IRC govern the taxation of employer- provided group- term life insurance coverage. Other types of life insurance, such as whole life or split- dollar life insurance, are also
discussed in this section.
Group‑ term life insurance
The value of employer- provided group- term life insurance up to $50,000 is excluded from an employee’s income. The value of coverage in excess of $50,000, minus any amount paid for the coverage by the employee after taxes, must be included in the employee’s income. The value of the excess coverage is subject to
social security and Medicare taxes, but is not subject to federal income tax withholding or federal unemployment (FUTA) tax. At their option, employers may withhold federal income tax on the value.
Nondiscrimination testing
The tax benefits of group- term life insurance (no inclusion in income below $50,000, valued at a special low rate above that amount) are not available to an employer’s “key” employees if the insurance
plan is discriminatory in favor of such employees.
Whole‑life insurance
