Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part IV. Business Income and Deductions
Chapter 20. Employee Benefits
And the Owner Benefits Too
Employee benefits are an additional expense that employers incur in order to attract and retain talented employees. Many of these benefits are tax-deductible to the employer, which can help reduce the true out-of-pocket cost to the employer. In some cases an owner is also eligible to take advantage of these “employee” benefits, which results in an even greater benefit to the employer by enabling him or her to transfer personal expenses to the business side of the equation. In this chapter we’ll discuss three types of employee benefits:
· Fringe benefits
· Educational assistance programs
· Medical expenses and health insurance
Fringe benefits are forms of payment to employees that are not given in the form of cash. Generally fringe benefits come in the form of the company paying for an item or service that benefits the employee. Most fringe benefits are taxable to the employee as wages. However, there are several that have been excluded from this treatment, allowing the bestowal of benefits to an employee, which are deductible to the employer but not taxable to the employee. This section will cover the following fringe benefits:
· Adoption assistance
· Athletic facilities
· De minimis benefits
· Employee discounts
· Life insurance
· No-additional-cost services
Employers may help in the cost of an adoption made by an employee as long as there is a written plan for such a benefit that does not favor highly compensated employees, and that all employees are made aware of. The reimbursed adoption expenses must be substantiated by sufficient documentation. The reimbursement is excluded from income; however, it is included for purposes of payroll taxes.
No more than 5% of the total reimbursed adoption expenses during a year may be paid to a shareholder or owner (someone who owns more than 5% of the business on any given day of the year).
The business can deduct the cost of an on-premises gym or other athletic facility, and not include it in employees’ wages, if the facility is used primarily by employees, their spouses, and their children during the year. This is one of the more lenient allowances for fringe benefits (one of the easiest to deduct). An individual is considered an employee if he or she meets one of the following criteria:
· A current employee
· A former employee who left because of retirement or disability
· A widow or widower of a person who died while an employee
· A widow or widower of a person who left because of retirement or disability
· A partner who provides services to the partnership
· A leased employee who is under the supervision of the business and has performed full-time service to the business for at least one year
The gym or athletic facility must be located on premises that are owned or leased by the business (not necessarily the primary place of business).
De Minimis Benefits
De minimis benefits are those items or services that you provide to an employee that have so little value that accounting for it would be unreasonable or administratively impractical. Such benefits include:
· Personal use of an employer-provided cell phone that is provided primarily for business purposes
· Occasional personal use of a business copy machine, as long as 85% of the machine’s use is for business purposes
· Non-cash holiday gifts with a low market value (such as a ham or turkey)
· Occasional tickets to theater or sporting events
· Snacks and drinks
Caution Cash and cash equivalents (such as a gift card), no matter how little, are never excludable: they must always be included in the employee’s income.
Your business may offer discounts on your products or services, as long as the policy for discounts does not favor owners or highly compensated employees. For services the discount may be up to 20% off of the price normally charged to non-employees. For products the discount may be up to the average gross-profit percentage of all products as a whole. For example, if you average a 50% gross profit on your products, the employee discount may not be more than that amount for any individual product.
You may provide up to $50,000 of group term life insurance per employee. Any excess amount that is provided will be included in the employee’s wages based on the premiums paid. The plan must not discriminate between employees or favor highly compensated employees or owners.
Services provided to an employee that add no additional cost to the business may be excluded from income. Examples of this would include airline employees receiving free flights, free telephone service to a phone-company employee, or free use of tax software for an employee of a tax-preparation business. To be considered “no-additional cost,” the service given must not have replaced the services that would have otherwise been given to a paying customer. For example, there must have been empty seats on a plane for an airline employee to use; they may not have used a seat that was needed by a paying customer.
As is the case with other fringe benefits, the services must not be provided in a way that favors highly compensated employees or owners. Also, services provided to employee family members are treated as if they were received by the employee.
Educational Assistance Programs
Your business may pay up to $5,250 per employee, per year, toward an employee’s education expenses. Qualified expenses include tuition, fees, books, equipment, and supplies required for bachelor- and graduate-level courses. However, no courses involving sports, games, or hobbies may be paid for unless they are directly related to your business or are required to obtain a degree. In addition, no tools or supplies may be paid for if they are retained by the employee after the course is completed.
Education assistance program policies must be written and made known to all employees. The qualifications for the program must not favor owners or highly compensated employees. The program may also not provide more than 5% of its yearly benefits to those who own more than 5% of the business. Note that children of owners who are bonafide employees are not under the limitations of the 5% rule.
Medical Expenses and Health Insurance
There are a few ways in which a sole proprietor can benefit from medical and insurance expenses by running them through the business instead of through their personal expenses. As you offer these benefits to employees, a significant portion of the cost will be offset by the tax deductions that you are able to claim for them and for yourself. The three areas covered in this subsection are:
· The Self-Employed Health Insurance Deduction
· Health Reimbursement Arrangements
· The Health Care Tax Credit
Self-Employed Health Insurance
On one occasion I was asked to review a new client’s personal tax return after his current accountant had filed it. As I looked at it, I realized that his Adjusted Gross Income (AGI) was only slightly higher than some key phase-outs that were having a significant effect on his return. I also noticed that he hadn’t claimed the above-the-line deduction for self-employed health insurance premiums, even though he qualified to do so. In fact, the amount that he paid for health insurance premiums during the year was larger than the amount by which his AGI exceeded the phase-outs that were affecting him. By amending his tax return and claiming the Self-Employed Health Insurance Deduction, we were able to save him save him thousands of dollars in taxes because of the credits and deductions that became available as a result of his AGI falling below the phase-outs.
Generally, health insurance premiums are considered a personal expense that can be deducted as part of the medical expenses deduction on Schedule A with all of the other itemized deductions. Claiming the deduction in this way makes the expense subject to the 7.5% or 10% AGI limitation, which often eliminates much (if not all) of the benefit of the deduction. It also means that the deduction has no benefit unless all of your itemized deductions combined together are greater than the standard deduction. These factors make it so that many people receive very little benefit from medical insurance expenses as a tax deduction.
However, if you own a business you can claim health insurance expenses as an above-the-line deduction instead of using them as an itemized deduction. To be eligible, you must be a sole proprietor, an active member of a partnership, or at least a 2% shareholder in an S-corporation to qualify. You must also have no employer-sponsored health insurance plan available to you (through your own employment or through your spouse’s employment). For example, if you are an employee of a business but also run your own business on the side, you could not claim this deduction if you are eligible as an employee to be covered under your employer’s insurance plan. However, if your spouse is eligible for insurance through her employer, but you are not, you can claim the cost of premiums for your own insurance.
The deduction cannot exceed your net earned income from the business, minus one half of your self-employment tax and minus any retirement plan contributions. For owners of S-corporations, the premiums must be paid by the corporation or reimbursed by the corporation and be reflected as income in the owner’s W-2 form.
Example Jill owns a bakery as a sole proprietor. Her net income from the business this year was $35,000. Her personal health insurance premiums were $5,000 for the year. She also made a $6,000 contribution to her IRA. Given these circumstances, Jill can claim the self-employed health insurance deduction because she has sufficient net income ($35,000 net income − $6,000 IRA contribution − $2,473 [one half of self-employment tax] = $26,527, which is greater than the $5,000 in health insurance premiums).
Health Reimbursement Arrangements (HRAs)
There is an IRS-approved conduit for deducting medical expenses as business expenses, which is known as a Health Reimbursement Arrangement (HRA). An HRA is a system in which the business reimburses its employees for medical expenses. The employer sets the terms of what will be reimbursed and is fully responsible for its funding (no employee contributions are allowed). Any reimbursements made for qualified medical expenses are deductible expenses for the business.
A self-employed business owner (sole proprietor) is not allowed to participate in an HRA program—at least directly. However, if the business owner’s spouse is employed by the business he or she would be allowed to participate. This strategy is explored further in Chapter 21. There are two major tax benefits to using an HRA program. First, medical expenses are deductible from the first dollar spent and not limited by the 7.5% or 10% of AGI floor normally placed on medical expenses claimed as an itemized deduction. Second, for self-employed individuals the deduction reduces income taxes and self-employment taxes, whereas the itemized deduction would not reduce the self-employment tax.
Caution As it currently stands, the Affordable Care Act (a.k.a. ObamaCare) puts severe limitations on HRAs beginning in 2014. It will be important to watch for any changes to this law to determine whether this will be a viable tax strategy in 2014 and beyond.
Health Care Tax Credit
To help cover the cost of insurance coverage, a credit is available to small businesses during the first five years of the Affordable Care Act. For businesses with 10 or fewer employees and an average employee salary of less than $25,000, the credit is 50% of the cost of premiums (or of the average cost in the state, if lower) for the coverage of employees (but not for the cost of covering the owners). The credit is only available to those businesses which buy their insurance through the government exchanges. It is quickly reduced for companies that have more than 10 employees, as well as for businesses that pay their employees better wages. The credit completely disappears if the average employee wages are higher than $50,000 or if the company employs more than 25 people. The owners and family members of owners are not counted in the employee number or in the average wages.
To qualify for the credit, the employer must pay at least 50% of employee premiums. The credit can be used against the Alternative Minimum Tax (AMT), but it is nonrefundable, so the employer will receive no help in paying for the insurance if he owes no taxes.
Tip This credit is not as beneficial as other credits. This is because the credit takes the place of the health insurance costs the business could have deducted if it had claimed no credit. This increases the company’s taxable income and thus reduces some of the credit’s benefit—at times making it not worth taking the credit at all.