What Are Fringe Benefits for Tax Purposes?

For U.S. federal income tax purposes, a fringe benefit is considered a form of pay for the performance of services, and is taxable unless the tax law specifically excludes it from taxation. Persons who perform services include employees, independent contractors, partners, and directors. Fringe benefits could also include payments or other benefits for not performing services, such as under a covenant not to compete, for example.

Provider of Fringe Benefits

The company or person for whom you perform services (your employer or the company that contracts you) is considered the provider of the fringe benefits and is responsible for including the fringe benefits in your compensation and withholding income tax. This is the case even though the benefits themselves may be furnished by a third party, such as an insurance company or health care provider, or one of your employer’s customers or clients, for instance. And, as the person who is performing the services, fringe benefits provided to a member of your family, or other dependent or beneficiary, are taxable to you.

General Rule on Taxability

Fringe benefits are taxable to the extent they are not specifically excluded under the income tax law, and to the extent you do not pay for them. In addition to income tax, fringe benefits are subject to employment, or payroll taxes (social security and Medicare) if you are an employee, unless they are specifically excluded.

Where Fringe Benefits Are Reported

The value of fringe benefits that you receive as an employee are included in box 1 of your Form W-2, Wage and Tax Statement, and may also be reported separately in box 12 with the appropriate code. If you are an independent contractor, the value of the fringe benefits would be included in your Form 1099-MISC, and if you are a partner, in Schedule K-1 (Form 1065).

Cafeteria Plans

A cafeteria plan allows employees to choose between receiving cash or taxable benefits instead of certain qualified benefits that could be excluded from tax.

Taxability of Qualified Benefits

If an employee chooses a qualified benefit, the fact that cash or a taxable benefit could have been chosen does not make the qualified benefit taxable. Therefore, qualified benefits provided under a cafeteria plan can be tax-free. Cash payments or unqualified benefits would be taxable.

What Can Be Included

Cafeteria plans do not normally include any deferred payment benefit plans, although they can include a qualified 401(k) plan. Other qualified benefits that could be included in cafeteria plans are accident and health benefits (but not medical savings accounts or long-term care assistance), adoption assistance, dependent care assistance, and group-term life insurance coverage.

What Cannot Be Included

A cafeteria plan cannot include Archer medical savings accounts, athletic facilities, de minimus benefits, educational assistance, employee discounts, lodging on business premises, meals, moving expense reimbursements, no-additional-cost services, transportation (commuting) benefits, tuition reduction, working condition benefits, or scholarships or fellowships. These benefits are treated separately.

Plans that Favor Highly Compensated Employees

If a cafeteria plan favors highly-compensated employees, in terms of eligibility to participate, and the contributions and benefits provided, the beneficiaries’ compensation will include the value of the taxable benefits they could have selected. Highly compensated employees, for this purpose, include officers and shareholders who own more than 5% of the employer’s stock, employees who are highly compensated based on the facts and circumstances, and the spouses and dependents of any of these employees.

Plans that Favor Key Employees

As in the case of highly-compensated employees, if a plan favors key employees, they are taxed on the value of taxable benefits they could have selected. A plan is considered to favor key employees if more than 25% of the total nontaxable benefits go to key employees. Key employees include officers who receive annual pay over a certain amount, employees who own at least 5% of the business, and employees who own at least 1% of the business and receive annual pay over a certain amount. The amounts may change year by year, and are published by the Internal Revenue Service.

Fringe Benefit Exclusions

Fringe benefit exclusion rules exclude part or all of certain benefits from federal income tax. In some cases, they also exclude benefits from social security and Medicare taxes.

Accident or Health Plan

Accident or health plans are arrangements that provide benefits for employees, their spouses, and dependents in the event of personal injury or sickness. Employer contributions may be made toward the cost of accident or health insurance, or to a separate trust or fund that provides accident and health insurance benefits either directly or through an insurance carrier.

Generally the value of coverage provided by your employer is not included in your taxable income for federal income tax purposes or social security and Medicare purposes. This exclusion applies to payments made directly to employees or beneficiaries, and payments made indirectly, on their behalf, and includes reimbursements of medical expenses, and payments for specific injuries or illnesses.

Whose Benefits Are Excluded

The exclusion of these benefits from taxable income applies to current employees, full-time insurance agents (statutory employees), retired employees, former employees for whom coverage is maintained based on the employment relationship, widows and widowers of former employees, and contracted persons (“leased” employees) who have provided services on a substantially full-time basis for at least one year.

Contributions made through a cafeteria plan must be included in income. These would be reported on your W-2.

Exception for Long-term Care Benefits

The cost of long-term care insurance is not exempt from federal income tax if coverage is provided through a flexible spending or similar type of arrangement that reimburses specified expenses up to a certain maximum amount. But these benefits are excluded from social security and Medicare taxes.

Exception for Highly Compensated Employees

A self-insured medical reimbursement plan that favors highly compensated employees is subject to income tax, but is exempt from social security and Medicare taxes. For this purpose, a highly compensated employee is:

• One of the five highest paid officers,
• An employee who directly or indirectly owns more than 10% of the employer’s stock, or
• An employee who is among the 25% highest paid of all employees.

Archer MSA Contributions

Contributions your employer makes to your Archer MSA (Medical Savings Account) are not included in your taxable income. They are reported in box 12, code R on your W-2, and you should report them on Form 8853, Archer MSAs and Long-Term Care Insurance Contracts.

Health Flexible Spending Arrangements (Health FSA’s)

If your employer’s plan qualifies as an accident and health plan, the amounts deducted from your salary or wages and the benefits paid for you and your dependents are generally not taxable. This same exclusion applies for Health Reimbursement Arrangements (HRAs).

Achievement Awards

Tangible personal property received as an award for length of service or other type of achievement is not subject to tax. This exclusion does not apply to cash, stocks, bonds, securities, gift certificates, or intangible awards such as vacations, meals, lodging, or tickets to sporting or other events.

Adoption Assistance

The amounts your employer pays or the expenses it incurs in connection with the adoption of your child are exempt from federal income tax, but are subject to social security and Medicare taxes. These amounts are reported on your W-2, in box 12, code T. You will need to complete Form 8839, Qualified Adoption Expenses, to see if you can exclude all or part of these benefits from your taxable income.

Athletic Facilities

If your employer allows you and your dependents to use a gym or other athletic facility on the employer’s premises, the value is not included in your compensation and is not taxable. The athletic facilities must be on property owned or leased by your employer, but do not necessarily have to be on its business premises. The athletic facility must be principally for use by employees, their spouses, and dependent children during the entire year. However, if your employer pays for an athletic program at an off-site facility, the value of the program is taxable income to you.

De Minimus (Minimal) Benefits

The value of products and services that your employer provides you, that have a low cost, such as a company cafeteria, cab fares home when working overtime, and company picnics, are not included in your income. If your employer gives you a holiday gift, such as a ham or turkey, this is not included in your income either. But if your employer gives you cash, a gift certificate, or a similar item that can be readily converted to cash, that amount is included in your taxable income.

Dependent Care Benefits

These are benefits that your employer pays directly to you or to a care provider to care for your qualifying person while you work, or the fair market value of care in a daycare facility provided or sponsored by your employer. These benefits are reported in box 10 of your W-2. You can exclude these benefits from your income, up to a maximum of $5,000 ($2,500 if married filing separately). Any benefits over $5,000 will be included in box 1 of your W-2 as taxable compensation.

To exclude dependent care benefits paid or provided by your employer, you will need to file Form 2441, Child and Dependent Care Expenses, if you file Form 1040, or Schedule 2 if you file Form 1040A.

Dependent care benefits that favor highly compensated employees are not excludible. For these purposes, a highly compensated employee is one who owned 5% or more of the employer’s stock at any time during the current or preceding year, or who earned over a certain amount (published by the IRS) and was in the top 20% of employees in terms of pay ranking during the preceding year.

Educational Assistance

You can exclude up to $5,250 of qualified educational assistance payments provided by your employer, for undergraduate or graduate level studies. In order to qualify, the program must meet the following tests:

• Rules for qualifying for educational assistance do not favor highly compensated employees.
• Not more than 5% of the program’s benefits during the year are for shareholders or owners.
• The program does not allow employees to choose cash or other taxable benefits instead of educational assistance.
• The employer gives notice of the program to all eligible employees.

The program can cover current employees, former employees if the benefit is based on their employment, leased employees who have performed substantially full-time services for at least one year, yourself (if you are a sole proprietor), and partners, in the case of a partnership.

Highly compensated employees, for purposes of the educational assistance program tests, are defined the same as for dependent care benefits programs.

Employee Discounts

If your employer sells you property or services at a discount, you may be able to exclude the discount from your income. The discounts must be on property or services your employer sells to customers in the ordinary course of the line of business.

Excludible discounts apply to current employees, former employees, widows and widowers of former employees, leased employees, and partners who perform services for a partnership.

There are limits on the amount of discounts that can be excluded from income:

• Discounts on services cannot be more than 20% of the amount charged to regular customers.
• Discounts on merchandise or property cannot be more than the business’s gross profit percentage on the price normally charged to regular customers.

Discounts are not excludible if they are granted only to highly compensated employees, and not to all employees or to a group of employees defined according to a reasonable classification that does not favor highly compensated employees. Highly compensated employees, for purposes of the employee discount, are defined the same as for the educational assistance program tests, and the dependent care benefits programs.

Financial Counseling Fees

Financial counseling fees paid for you by your employer are included in your taxable income. But you may be able to deduct these expenses on Schedule A as a miscellaneous itemized deduction.

Employer-Provided Vehicles

Personal use of an employer-provided vehicle is a taxable non-cash fringe benefit. Your employer must determine the amount to be included in your income as reported on your W-2. This would generally be the fair market value, which would be the amount you would have to pay a third party to lease the same or a similar vehicle on the same or comparable terms in the geographic area where you use the vehicle.

If you use the vehicle for both personal and business use, you may be able to take an itemized deduction for the business use of the vehicle.

Meals and Lodging

The value of meals and lodging provided to you and your family by your employer are not included in your taxable income if:

• The meals and lodging are furnished on your employer’s business premises,
• The meals and lodging are furnished for the convenience of your employer, and
• The lodging is a condition of your employment.

This exclusion also applies to de minimis meals, or meal money that has so little value that accounting for them would be unreasonable or impracticable. This includes items such as coffee, doughnuts, soft drinks, occasional meals or meal money for working overtime, and occasional company parties or picnics for employees and their guests.

Company-provided eating facilities are also excluded from income if the annual revenue of the facility equals or exceeds the direct cost of operating the facility. Meals provided at a company facility for highly compensated employees, that are not available to all employees or to a group of employees that does not favor highly compensated employees, are not excludible.

Whether meals are provided for the convenience of the employer depends on the circumstances. There must be a substantial business reason for providing the meals. For this purpose, if more than half of the employees are provided with meals for the convenience of the employer, it is considered that all employees are provided meals for the employer’s convenience, and they are excludible from the employees’ taxable income.

Moving Expense Reimbursements

If your employer directly or indirectly pays for moving expenses that would have been deductible if you had paid them, the payments are not included in your income. If your employer pays you a moving expense allowance, you should include it in your taxable income and report your actual moving expenses on Form 3903.

No-Additional-Cost Services

These are excess capacity services such as airline, bus, or train tickets, hotel rooms, or telephone service provided to you as an employee for free, at cost, or at a reduced price. These are not included in your income if your employer provides the same services to customers in the ordinary course of the line of business, and it does not have a substantial additional cost to provide you with the services.

Reciprocal agreements for an unrelated employer to provide no-additional-cost services may qualify for exclusion if the following tests are met:

• The service is the same type of service provided by your employer in the line of business in which you work.
• Your employer and the unrelated employer have a written reciprocal agreement under which a group of employers from both employers may receive no-additional-cost services from the other employer.
• Neither employer incurs any substantial additional cost in providing the service.

Group-Term Life Insurance

The cost of group-term life insurance coverage provided by your employer is exempt from federal income tax, and up to $50,000 of group-term life insurance coverage is also excluded from wages subject to social security and Medicare taxes. The cost of coverage over that amount is subject to social security and Medicare tax, and will be reported in box 12, code C on your W-2.

In order to qualify as excludible, the group-term life insurance must provide a general death benefit that is not included in employees’ income, the policy must cover at least 10 full-time employees, and the insurance must be based on a formula that prevents individual selection.

There are certain exceptions to the 10 full-time employee requirement:

• Evidence of an employee’s insurability must be limited to a medical questionnaire and not a physical.
• Insurance is provided to all full-time employees.
• Coverage must be based on a uniform percentage of pay, or the insurer’s coverage brackets.

Employees for this purpose include current employees, full-time insurance agents (statutory employees), former employees, and leased employees who have provided substantially full-time services for at least one year.

The cost of coverage in excess of $50,000 must be included in employees’ compensation subject to social security and Medicare taxes, reduced by the amounts employees pay for this coverage.

If group-term life insurance favors key employees, the entire cost of the coverage is included in those key employees’ wages subject to social security and Medicare taxes.

Retirement Planning Services

Retirement planning services provided by your employer are not included in your income. This does not apply to services for tax preparation, accounting, legal, or brokerage services.

Transportation

Qualified transportation fringe benefits provided by your employer can be excluded from your income up to certain limits. Qualified benefits include the following, up to a certain amount per month, which may change year by year. These amounts can be found in IRS instructions and publications:

• Transportation in a commuter highway vehicle (such as a van) between your home and work place,
• A transit pass (for mass transportation fares), or
• Qualified parking.

If the transportation benefit exceeds the exclusion amounts, the excess is taxable income to you.

Retirement Plan Contributions

The contributions your employer makes to a qualified retirement plan for you are not included in your taxable income at the time the contributions are made. But if your employer makes payments into a plan that is not qualified according to the IRS, these contributions would be taxable to you. However, if your interest in the plan is not transferable to you, or is subject to a substantial risk of losing it at the time of the contribution, you do not have to include the value of that contribution in your income until it is transferable or is no longer subject to a substantial risk of forfeiture.

Outplacement Services

Outplacement services qualify for exclusion from income as a working condition benefit; to the extent you could deduct the expense if you had paid for it yourself (as a job hunting expense under miscellaneous itemized deductions). The outplacement services would not be excludible if you could choose to receive cash instead. For example, if you agree to accept outplacement services in exchange for a reduction in your severance pay, the amount of the reduction would be included in your taxable income.