Determining What Constitutes Taxable Compensation
Compensation takes many forms: some types are subject to payroll taxes and some are not. Advances and loans, gifts, awards, and prizes, employee fringe benefits, business expense reimbursements, vacation and other time-off pay are among the types of compensation that you'll need to analyze in order to fulfill your withholding and payment obligations as an employer. In addition, special rules apply to noncash wages and payments for what is considered casual labor.
Determining whether compensation you pay your workers is subject to payroll taxes may not seem like a very complex issue. However, there are different types of compensation and discerning what portion of the compensation you pay workers is taxable is not as straightforward as you might imagine.
Defining Wages for Payroll Tax Purposes
The federal and state payroll tax laws generally identify taxable compensation as being an employee's wages. The definition of wages is quite broad and encompass almost every payment you make to an employee for services.
Is how you characterize a payment relevant? No. The label you give a payment, whether you call it a commission or a fee or by some other name is unimportant in determining whether it constitutes wages.
Other immaterial factors include:
- whether a payment is designed to supplement an employee's basic salary
- the payment is not made in cash
- the basis on which the payment is made (for example, whether the payment is based on a percentage of profits or hours worked)
So basically, the rule is whenever you transfer something of value to an employee as compensation for the employee's services, you've potentially made a taxable wage payment.
Wage caps and floors. The definition of taxable wages is basically the same for each of the different payroll taxes. What this means is that a specific type of compensation or benefit generally will either be taxable or nontaxable for purposes of all of the taxes. However, the dollar amount of wages that is subject to each of the taxes will not necessarily be the same. Some of the taxes apply only up to a maximum amount of wages, while another of the taxes does not even apply unless wages have reached minimum thresholds.
Specifically, wage caps apply to the FICA Social Security tax, to federal (FUTA) and state unemployment taxes, and to state disability insurance taxes. However, the 1.45 percent FICA Medicare tax has no wage cap. The additional 0.9 percent Medicare surtax applies only after wages have reached certain thresholds.
Exceptions to the rule. As is common in the world of taxation, the laws do provide for a number of exceptions where some types of compensation and fringe benefits are not always considered taxable wages, for some or all payroll tax purposes. These exceptions include:
- advances and loans
- vacation and other time-off pay
- gifts, awards, and prizes
- business expense reimbursements
- employee fringe benefits
- non-cash payments
- casual labor
Repayment Obligation Determines If Loans and Advances Are Wages
In general, payments you make to your employees for services they'll perform or complete in the future are considered taxable wages for all payroll tax purposes.
You employ Karinna as a salesperson and pay her on a monthly commission basis. Each week you advance Karinna $150 against her future commissions. If the advances exceed Karinna's commissions for the month, you carry the excess as an account due from future commissions. However, Karinna has no obligation to repay that account if she quits while her account has an outstanding balance. Therefore, the advances are considered taxable wages when paid.
Advances are not taxable compensation if the employees are legally obligated to repay the advanced amounts. In our example, if you required Karinna to sign a note or agreement that obligated her to repay the advanced amounts upon your demand or upon specified events (for example, his termination from employment), the advances would likely be considered nontaxable loans rather than taxable wages.
Advances for expenses aren't taxable wages. Advances you give employees to cover business expenses they're reasonably expected to incur while conducting business on your behalf are not taxable wages if the advances are for deductible expenses, and you require employees to report what they spend. This is the same rule that applies when you reimburse employees for expenses they've incurred. In other words, as long as the advances are made under an "accountable plan," they are not taxable wages.
Vacation and Other Time-Off Pay Are Generally Wages
If you've extended your employees the benefit of paid vacation time, these payments are considered taxable wages. The same rule applies if you give extra pay to employees who do not take their vacations and are not absent from work, to compensate them for the extra time that they could have taken off.
This general rule applies to most other payments you make while employees are not at work, including holiday pay, sick pay, maternity or paternity leave, military leave pay, and disability pay.
Special rules for jury duty pay. In general, any pay you give your employees while they are serving on jury duty is considered taxable wages for payroll tax purposes. However, the taxable amount can differ depending on how you treat your employees' jury duty pay:
- If you reduce your employees' regular wages by their jury duty pay, your payroll tax obligations apply to the reduced wage amount.
- If you pay your employees their regular wage, but require them to assign their jury pay to you, your payroll tax obligations apply to the regular wage amount as reduced by the assigned jury duty pay.
- If you pay your employees their regular wage and allow them to keep their jury duty pay, your payroll tax obligations apply to only the regular wage amount.
Are Gifts, Awards, Prizes, and Business Expense Reimbursements Taxable Wages?
Based on the employee-employer relationship, most gifts that you give to your employees are presumed to be compensatory in nature. What this means is that unless you can show that a gift is connected with an event that's totally unrelated to your business (for example, you attend an employee's wedding), gifts to your employees are considered taxable wages for payroll tax purposes.
Gifts of property are treated no differently from monetary gifts.
There is an exception to the rule during the Christmas holiday season. Christmas gifts are not considered taxable wages only if the gifts are items of property having nominal value (for example, a turkey or a ham). However, this exception is limited to property and does not apply to gifts of cash, no matter how nominal.
Payroll Tax Obligations for Performance-Related Awards and Prizes
Employee prizes and awards are generally considered taxable wages, on the theory that you present them in return for an employee's performance or services.
However, there is an exception from the general rule. There are three limited circumstances under which you may be relieved from payroll tax obligations on noncash awards:
- Employee achievement awards of tangible personal property that are awarded to an employee because of the employee's length of service (including retirement), productivity, or safety achievement, made under a written plan that does not discriminate in favor of highly compensated employees, and which average $400 or less during the year, are not taxable wages. They are considered "qualified" plan awards.
- Other awards are considered "nonqualified" and no more than $400 in nonqualified awards can be exempt from taxable wages for any one employee. Up to $1,600 in total awards, both qualified and nonqualified, will be exempt from wages for any one employee per year.
- When you give a noncash award to a retail commission salesperson whom you ordinarily pay only cash commissions, you can elect not to withhold federal income taxes with respect to the award. However, you will remain responsible for FICA taxes, unemployment taxes, and possibly state income taxes on the award.
Payroll Tax Rules for Business Expense Reimbursements
Many businesses reimburse their employees when the employees pay for business-related travel, entertainment, or other types of expenses. But how can you make sure that these reimbursements will not trigger additional payroll taxes for you and your employees?
First of all, the expenses must be bona fide, ordinary and necessary expenses incurred or reasonably expected to be incurred to further your business. The IRS's main concern is that you are not trying to write off personal living expenses, or perks that are mainly designed to provide additional pay to the employees. Therefore, each type of expense must meet the regular IRS rules (if any) for deducting that type of expense; for example, meals and entertainment expenses are only deductible under certain circumstances, and there are strict rules for deducting car-related business expenses.
If that test is met, you still have another hoop to jump through. The advances and reimbursements will still be taxable to the employee unless they are made under an "accountable plan." An accountable plan is one that has the following three characteristics:
- It provides for advances or reimbursements for deductible business expenses that employees incur in connection with their performance of services for their employer.
- It requires employees to substantiate the expenses (i.e., with receipts and detailed expense reports) within a reasonable time.
- It requires employees to return any advances or reimbursements in excess of substantiated expenses within a reasonable period of time.
Any amounts you pay to employees that exceed the substantiated expenses are taxable wages, unless the employee returns the excess to you within a reasonable period of time.
If the reimbursements are not made under an accountable plan, the payments will be subject to payroll taxes.
Your employee may be able to deduct reimbursements not made under an accountable plan and subject to payroll taxes as employee business expenses, which are included as miscellaneous itemized deductions, on his or her individual income tax return.
Which Employee Fringe Benefits are Subject to Payroll Taxes?
Many employee fringe benefits are exempt from payroll taxes, both Federal Insurance Contributions Act (FICA) or Federal Unemployment Tax Act (FUTA) taxes, as long as certain requirements are met. And because they are not taxable to the employee for income tax purposes, there is no need to withhold income tax on the value of the payments. There are certain fringe benefits that are not totally exempt from payroll taxes. For example, an employee fringe benefit may be exempt from withholding, but still subject to FICA and FUTA taxes.
The following is a list of employee fringe benefits at least partially exempt from payroll taxes:
- health plan payments, including both insurance premiums and payments from health plans for medical expenses, to or on behalf of an employee, employee's spouse, or employee's dependents
- long-term care insurance premiums and payments
- any sick pay or disability payments made later than six months after the employee last worked for you
- payments made on account of retirement for disability or death, including wages earned before the employee died but paid to a survivor after the year of death
- employer's contributions to a qualified pension or retirement plan, including profit-sharing, SEP, or SIMPLE plans (employees' elective contributions to retirement plans, such as contributions to 401(k) or SIMPLE plans, are subject to FICA and FUTA taxes but not income tax withholding)
- group-term life insurance premiums on policies of up to $50,000 per employee
- workers' compensation premiums and benefits
- up to $5,250 in nongraduate and graduate school employer-provided educational assistance, regardless of whether the education is job-related
- meals and lodging furnished for the employer's convenience to employees and their dependents
- dependent-care assistance, up to $5,000 per employee
- services that your business provides to an employee at no additional cost to yourself and that you offer for sale to your customers; generally speaking these are "excess capacity" services like free standby air travel for airline employees, free hotel rooms for hotel employees, etc.
- certain employee discounts on the products or services you sell (the discount on services may be up to 20 percent; the discount on products may be as high as your gross profit percentage)
- property or services that you provide to an employee and for which the employee would have been entitled to a tax deduction had the employee paid you for the property or services (examples: company car used for business purposes, safety equipment, job training)
- benefits that have minimal value, such as occasional parties, occasional supper money or taxi fares when an employee works late, occasional tickets to entertainment or sporting events, use of company telephone or copy machines for personal purposes, etc.
- reimbursements for qualified moving expenses; generally this includes the cost of packing and transporting household goods and personal effects, and of transporting the employee and his or her family from the former residence (including lodging en route); the new job location must be at least 50 miles farther from the employee's former home than the old job location, and the employee must work full time for at least 39 weeks during the first 12 months after the move
- up to $245 per month per employee in mass transit passes or vanpooling services and up to $245 per month in parking benefits (these amounts are for 2013 and may be adjusted annually)
- excludable bicycle commuting benefits of up to $20 for each month in which an employee regularly commutes by bicycle (bicycle commuting benefits are not excludable if employees can choose between receiving the benefit or receiving cash)
- athletic facilities such as a gym or swimming pool located on the business premises, and operated substantially for the use of employees, their spouses, and dependent children
- qualified adoption assistance expenses (up to $12,970 for 2013 ($12,650 for 2012) per eligible child), are not subject to income tax withholding, although these expenses are subject to FICA and FUTA taxes
- differential pay that employers pay to their employees that leave their job to go on active military duty is subject to income tax withholding, but is not subject to FICA or FUTA taxes; employers may use the aggregate procedure or optional flat rate withholding to calculate the amount of income taxes required to be withheld on these payments, and these payments must be reported on Form W-2
You have some flexibility in designating when taxable fringe benefits are paid for purposes of determining when your payroll taxes on the benefits are due.
The general rule is that you may treat a benefit as having been paid on your regular payday or on any other periodic basis ( for example, monthly or quarterly), provided you treat them as having been paid at least as often as once a year.
Payroll Tax Responsibilities for Noncash and Casual Labor Payments
Because virtually anything of value that you transfer to your employees as compensation for their services constitutes taxable wages, wages in the form of property are subject to payroll taxes to the same extent as cash wages, with exceptions for tips and payments for casual labor,
Therefore, payments made in the form of food or lodging are generally taxable to the employee, unless they are made in that form for the convenience of the employer, and:
- in the case of meals, they are taken on the business premises
- in the case of lodging, the employee is required to accept lodging on the business premises as a condition of employment
When meals are provided on the business premises to at least half the employees for the convenience of the employer, the value of the meals is not taxable to any of the employees who receive meals.
One of the first problems you'll encounter when you choose to compensate employees with food, lodging, equipment, or other noncash items is determining how much you paid. How do you determine the value of noncash items?
For noncash payments, the general valuation rule is that the amount of taxable wages is the fair market value of the benefits or property at the time of payment. In general, "fair market value" is the amount an individual would pay an unrelated third party to obtain comparable benefits and property. So, although you and your employee may agree on an appropriate value for the noncash payment, that agreed-upon value will not necessarily be accepted by the IRS and tax authorities.
There are exceptions to the general valuation rule for certain nonexempt fringe benefits subject to special rules. For example, there are special rules that apply to an employee's use of a vehicle: the automobile lease valuation rule, the vehicle cents-per-mile valuation rule, the commuting valuation rule).
Most state unemployment agencies have regulations stating the minimum values that can be used for room and/or board, for state unemployment tax purposes. You can consult your state department of labor for more details.
Perhaps the biggest problem with paying an employee noncash wages is that you must see to it that the income taxes and FICA taxes that you're required to withhold on these items are available for collection. This isn't difficult if you also pay the employee cash wages because you can withhold all the required taxes from the cash remuneration. If you don't pay any cash wages or if the cash wages you pay are insufficient to cover all of the withholding taxes, you must try to get the necessary funds from the employee. Unfortunately, this is frequently easier said than done.
If you are going to pay noncash wages to your employees, especially if it's at their request, get a written commitment from them that they'll turn over to you any funds necessary to meet a tax withholding shortfall.
Also, be careful not to create additional underwithholding issues by using your own funds to make up the shortfall. By using your own funds to make up the shortfall you've effectively paid additional wages to the employees and will thus incur additional payroll tax liabilities.
Payments for Casual Labor
Occasionally, you may pay workers to do work that does not promote or advance your business. For example, during a slow business period you may pay an employee to do some work around your home, such as paying one of your computer techs to set up your home entertainment system. Special rules apply to the amounts you pay your employees for such "casual" labor:
- Unless certain dollar thresholds are met, your payments to those employees will not constitute taxable wages for payroll tax purposes.
- Noncash payments for casual labor aren't taxable. (However, you can't deduct your payments for personal services as a business expense).
Income and unemployment taxes. You're not required to withhold federal and most state income taxes or to pay federal (FUTA) and state unemployment taxes with respect to your cash payments to an employee for casual labor unless:
- the cash payment is $50 or more in a calendar quarter, and
- the employee was engaged in casual labor for some portion of 24 different days during that quarter or during the preceding calendar quarter.
You're not required to withhold or pay FICA taxes with respect to your cash payments to an employee for casual labor unless the payments amount to $100 or more during the calendar year.
Rules for payments for domestic services. Generally, you're not required to withhold or pay federal income tax for domestic services performed by an employee in your home.
You do have to pay FICA taxes for cash payments of over $1,800 (for 2012 and for 2013) to domestic service employees, but noncash payments are exempt from FICA taxes. And if you pay domestic workers $1,000 or more per calendar quarter in the current or preceding calendar year, you are subject to FUTA taxes. An exception to the FUTA requirement applies to wages paid to a spouse, parent, or child under the age of 21.
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