Strengthening employers' hands: the ABCs of tax smart fringe benefit program design.
Definition and Types of Fringe Benefits
The term "fringe benefits" is not defined in the income tax code. However, the phrase is generally understood to mean benefits provided by an employer to its employees (or others performing services for the employer) other than salary or wages for services rendered. These benefits may take many forms, including: cash payments; providing privileges, goods, services or facilities to employees; allowing employees to use employer property; providing intangible benefits (such as time off with pay); or giving employees the right to receive stock of the employer.(1) Although generally thought of as being tax-free, fringe benefits are excludable from income only if so specified by the tax code. Hence, some benefits are excludable for both federal income tax and FICA tax purposes, some are excludable only for federal income tax purposes and others are fully taxable.
Fringe benefits can be classified into three types: insurance benefits, deferred compensation plans and incidental benefits.
The benefit provided by the employer in this instance consists of the premiums paid on behalf of the employees. If the fringe benefit meets excludability requirements, neither the value of the premium payment made by the employer, nor the benefit payments made by the insurance company are taxed to the employee. Insurance benefits to be discussed here are group-term life, ordinary whole-life insurance policies, health and accident insurance, and legal services insurance.
Premiums paid by the employer on the first $50,000 of group term life insurance coverage on the employee (spouses and dependents are not eligible) are excludable from income under Code Section 79. Coverage in excess of $50,000 is taxable after deducting all premium payments made by the employee. The plan must be in writing and must meet nondiscrimination requirements. To determine the taxable amount, the IRS publishes uniform premium tables that determine the cost per month per thousand broken into age groups.(2)
Ordinary whole-life policies are not an excludable fringe. Thus, if the employee is the owner of the policy and the employer pays the premiums, the premium payments must be included in gross income of the employee. If the employee is merely the insured, but the employer owns the policy (e.g., key-man life insurance policies), the employee has no income resulting from the policy.
Health & Accident Policies
If the employer pays premiums for a health and accident policy on the employee, his spouse and dependents (or makes trust fund contributions in self-funded arrangements), the employee may exclude the premium payments from income provided the plan is written and nondiscrimination rules are met. However, the tax status of the benefits depends on the type of benefit payment. Payments received for medical care and loss of a member or function of the body are excludable. Payments received for income reimbursement under disability plans are taxable (although workmen's compensation is excludable) to the extent that the employer has paid the premiums.
An employee may, under Code Section 120, exclude from gross income amounts contributed on behalf of the employee, spouse and dependents toward premiums on a group legal services plan as well as the value of legal services provided by the plan or amounts paid for legal services. Specific discrimination and participation requirements apply to qualified group legal services plans.
Deferred Compensation & Restricted Property Plans
Some deferred compensation and restricted property plans are nonqualified, i.e., they do not qualify for exempt status under the pension and retirement laws. However, a major advantage of unqualified plans is that they need not meet nondiscrimination or participation requirements and can be limited to key executives if desired.
The specific purpose of such a deferred compensation plan is to provide resources for key employees without their being taxed currently on those resources. A typical scenario would be an employment contract which called for, in addition to a yearly salary and benefits, the payment of a lump sum or a certain amount per year at the end of a term of service or at retirement. If (as is almost always true), the employee uses the cash basis method of accounting, deferred compensation plans will not be taxed until payments are received, provided that the cash equivalency doctrine and the constructive receipt doctrine are avoided.
Funded Nonqualified Plans
Funded nonqualified plan contributions are included in income of the employee for his taxable year in which the contribution is made if the contribution is nonforfeitable at that time. If, on the other hand, there is a "substantial risk of forfeiture," the contribution is not taxed until the risk of forfeiture is lifted. A "substantial risk of forfeiture" exists where rights are either conditioned upon future performance of services or upon the occurrence of a condition related to the transfer. The possibility of forfeiture must be substantial if the condition is not satisfied.(3) Often, so called "Rabbi trusts" are used as a vehicle to set aside money for the plan. The Rabbi trust will not constitute funding if the assets of the trust are available to creditors in the event of bankruptcy or insolvency of the company. The constructive receipt and cash equivalency doctrines apply in determining whether a plan is funded.
Participants in an unfunded plan have only the written contract or agreement which promises future payment as evidence of the intent to pay the compensation. Unfunded plans are not taxed to the employee until payment is made to the employee. The employer also receives a deduction at that time.
Restricted Property Plans
Restricted property plans are covered by Code Section 83 (this includes restricted stock of the employer). The general rule provided in Code Section 83 is that the fair market value of the property is included in gross income of the employee during the first taxable year in which the rights of the employee are transferable or are not subject to a substantial risk of forfeiture. As is pointed out in the regulations, whether a risk of forfeiture is substantial is very much a question of fact. The regulations indicate a requirement to return property if a person is discharged for cause is not a substantial risk of forfeiture. Likewise, a prohibition against accepting a job with a competing firm does not constitute a substantial risk of forfeiture.
Other benefits provided by statute include cafeteria plans, dependent care assistance plans, educational assistance plans, employee death benefits, meals and lodging, and miscellaneous benefits.
Section 125 authorizes cafeteria plans, in which an employee selects between cash and qualified tax-free fringe benefits. The result may be a combination of taxable, deferred and exempt benefits. Benefits which may be offered by a cafeteria plan are:
Type of Benefit Code Section Group term life insurance 79 Health and accident plans 105-106 Qualified group legal services plans 120 Dependent care assistance programs 129 Salary deferral arrangements 401(k) Paid vacation days Reg. 1.125-2
The design of cafeteria plans can range all the way from a "package plan," which provides employees alternatives in only the amount of coverage selected, to "free choice" plans where the employee has a number of options from which to select.(4)
Flexible spending accounts may be offered through a cafeteria plan. A flexible spending account enables employees to fund from pre-tax income (the contributions also avoid F.I.C.A. tax) an account which is used to pay directly or to reimburse for medical expenses and/or for dependent care assistance. Since many or all of the medical expenses would not be deductible by the employee if paid directly (medical expenses are subject to a 7.5% of AGI floor), flexible spending accounts can be of considerable benefit to employees. There are a number of requirements to be met for a flexible spending account to qualify as part of a cafeteria plan, one being that any amount not spent during the year is lost (the "use it or lose it" provision).(5)
Certain benefits are not permitted to be offered in a cafeteria plan. They include scholarships and fellowships, educational assistance, meals and lodging, and the four miscellaneous fringe benefits provided in Code Section 132.
Cafeteria plans provide greater utility to employees because of their flexibility, i.e., the employee may pick and choose among the alternatives.
Dependent Care Assistance Plans
An employee may, under Section 129 exclude from gross income up to $5,000 per year ($2,500 for married filing separately) incurred by his employer for dependent care assistance. The dependent care assistance may take the form of services provided to the employee (such as a reduced-cost on-site day care center), amounts paid directly to a dependent care provider, or amounts reimbursed to the employee for expenses incurred. The plan must be in writing and Section 129 contains participation and nondiscrimination rules. To the extent that the employee excludes dependent care assistance from income, the child care credit base is reduced.
Education Expense Reimbursements
Certain amounts paid by employers for the education of their employees are excludable under Section 127. Amounts eligible for the exclusion are limited to tuition, fees, books and supplies. The assistance may not exceed $5,250 per year and may not pay for graduate study or involve sports, games or hobbies not related to the employer's business. Educational assistance plans must be in writing and are subject to discrimination and participation requirements. The exclusion is due to expire at the end of 1991;(6) however, Congress has extended the benefit several times in the past.
Section 101 provides that the beneficiaries or the estate of an employee generally may exclude up to $5,000 of benefits paid by reason of death of the employee. The $5,000 must be allocated among the various beneficiaries if payment is made to more than one person. Applicability of the death benefit exclusion depends on whether the distribution is in the form of a lump-sum or in the form of an annuity.
Lump-sum payments are excludable up to the $5,000 limit; however, amounts paid as compensation, e.g., uncollected salaries, are not eligible for the exclusion. If the payment is from a nonqualified pension, profit-sharing or stock-bonus plan, only payments in excess of the nonforfeitable rights of the employee are eligible for the exclusion.
Meals and Lodging
The value of meals and lodging furnished to an employee, spouse and dependents of an employee is excludable from gross income under Section 119 if furnished for the convenience of the employer. However, an additional requirement must be met. In the case of meals the additional requirement is that the meals be furnished on the business premises. There is a stricter requirement for lodging: employees must be required to live on the premises as a condition of their employment.
Miscellaneous Fringe Benefits
Section 132 provides for four miscellaneous fringe benefits. They are:
1. No-additional cost service;
2. Qualified employee discount;
3. Working condition fringe; and
4. De minimis fringe.
A "no-additional cost service" is defined as any service provided to an employee if the service is offered for sale to customers and the employer incurs no substantial additional cost in providing the service to the employee. The service must be in the line of business in which the employee works. An example would be a free ticket to an airline employee.
A "qualified employee discount" is any discount which does not exceed:
1. for property -- the gross profit percentage at the price offered to customers; or
2. for services -- 20% of the price at which the services are being offered by the employee to customers.
A "working condition fringe" is any property or service provided to an employee to the extent that if the employee paid for the item, it would be deductible as either a business expense or as depreciation. Examples include the value of use by an employee of a company car for business purposes or the provision of a bodyguard to the employee.
"De minimis fringes" refer to property or services which are so small in value as to make accounting for the fringe benefit either unreasonable or administratively impractical. Included are such items as: typing personal letters by a secretary; company picnics; occasional supper money; holiday gifts of property with a low value; and occasional sporting event tickets. Subsidized meals are generally excludable under this provision, provided that the revenue from the eating facility covers the direct costs of operation.
Fringe benefit plans can be used as an effective tax planning tool, as well as an avenue to greater employee satisfaction. A combination of qualified plans and non-qualified plans can enhance the compensation package of managers, executives and owners. However, many benefits are not available to self-employed individuals, partners or S corporation shareholder-employees. Thus, the availability and tax treatment of fringe benefits should be a critical consideration in the choice of the tax entity.
The requirements for various types of benefits are found in a number of statutes -- e.g., the Internal Revenue Code, the Employee Retirement Income Security Act, the Federal Insurance Contributions Act, and the Federal Unemployment Tax Act. Administrative costs involved in fringe benefits plans may be considerable, especially in complying with nondiscrimination rules. Since the penalties for violation of these rules are steep, hiring a consultant is often wise.
Working couples have a much greater interest in fringe benefits than say 20 years ago. Working couples desire such fringe benefits as child care facilities, expanded maternity and paternity leave and legal services.
Cafeteria plans are especially useful to working couples because their flexibility can help working couples to avoid redundant benefit plans. In summary, the firm may enhance its position with employees and may minimize its tax liability by carefully considering and choosing an appropriate mix of deferred, insurance based, and incidental fringe benefits.
The three tables following this article graphically present the guidelines discussed in designing employee fringe benefit packages.
1 "Employee Fringe Benefits," Tax Management Portfolio 394, p. A-1
2 Temp. Reg. 1.79-3T
3 Reg. 1.83-3(c)(1)
4 For a good discussion of the various types of cafeteria plans commonly offered, see Doyle, Margaret M., "Cafeteria Plans Offer Benefits, but the Price is Compliance with Complex Rules," Taxation for Accountants, Vol. 43, No. 3, (1989).
5 For an excellent discussion of flexible spending accounts, see Sumutka, Alan R., "Flexible Spending Accounts," The Tax Adviser, Vol. 20, No. 1 (1989). Caution: proposed regulations on cafeteria plans were issued after the article was published.
6 Provided Congress passes the Revenue Act of 1992 which should provide further extensions of the exclusion to December 31, 1993.
Elizabeth A. Gildea is a graduate student in business at Iowa State University. Her undergraduate degree is from the University of Kansas. She works with employee benefit programs and speaks at seminars on mid-career financial and pre-retirement planning for employee groups.
Gary L. Maydew, PhD, CPA, is an associate professor of accounting at Iowa State University. He is the author of two books, has published articles in numerous professional journals and regularly conducts seminars on taxation and accounting topics.
Key for Fringe Benefit Tables
E = Employee of C corporation P = Partner S = Shareholder/employee of S corporation y = Yes n = No p = Partial
TABULAR DATA OMITTED
TABULAR DATA OMITTED
TABULAR DATA OMITTED
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||fringe benefits available under federal income tax law|
|Author:||Gildea, Elizabeth; Maydew, Gary L.|
|Publication:||The National Public Accountant|
|Article Type:||Cover Story|
|Date:||Oct 1, 1992|
|Previous Article:||Tax expert systems and benefits from using them.|
|Next Article:||Deductions for use of residence by day care providers.|