Cash and non-cash payments to employees

Business expenses are the costs a company incurs to carry on its trade, business or profession. The IRS allows businesses to deduct these expenses as long as the business is trying to make a profit. The general requirements for deducting employee compensation expenses were presented in the previous chapter. The purpose of this chapter is to present the requirements for deducting specific employee expenses. Employers will be able to use this information to decide if the company can deduct a specific expense, such as vacation pay, sick pay, bonuses, etc., that they incur during a year.

Employers generally provide compensation to employees in different ways. In this chapter, we will focus on cash and non-cash payments made to employees and the deductibility of such items as business expenses.

PAYMENTS IN CASH;

Bonuses: The most common type of additional pay to employees takes the form of bonuses. The IRS allows you to deduct employee bonuses if your intent is to provide the employee with additional payment for services rendered, and not as a gift. The bonus must still meet the four deductibility tests described in the previous chapter. Bonuses, while deductible to the company as a business expense, are included in the employee’s income, just like any other compensation. Bonuses simply increase the amount of total salary paid to an employee in any given year.

Gifts – Gifts that have a nominal value, such as a Christmas turkey or other similar items, are deductible as business expenses as long as they do not exceed $25 in fair market value. Such gifts are not included in an employee’s income, although the company may deduct tax on the gift. Since such items are classified as gifts, the employee does not need to perform any service for the item to be deductible to the employer. If the employer provides employees with gifts of cash, gift certificates, or other cash equivalents, these items are considered additional compensation, regardless of value, and must be included in the employee’s income. Accordingly, gifts must be ‘in-kind’ items and not cash or cash equivalents.

Deferred Compensation – Some employers pay their employees a set amount each pay period and carry over part of the total compensation until the next year. The deduction for this amount is based on the following:

1. Taxpayers using the accrual method can deduct the entire amount of the remuneration (including the deferred amount) in the year in which the worker provides services for the company. This means that if the employee rendered the services in one year, but the employer chose to defer the actual pay or part of the employee’s salary until the next year, the employer can still deduct the pay in the first year. Such an arrangement is only permitted if a final prior arrangement is made with the employee and the related party rules do not apply.

2. However, employers who use the cash method may only deduct the amount actually paid in the year in which the services are provided. Consequently, any deferral of compensation to an employee results in the loss of a deduction for the company.

There is a special rule for taxpayers by the accrual method with respect to related parties. Employers cannot deduct payments to related taxpayers until the amount owed is included on the taxpayer’s return. For these purposes, a related taxpayer includes the immediate members of a family who own more than 50% of the shares of the corporation. In these situations, the accrual method employer is placed on cash basis to deduct deferred compensation. Thus, owners of closely held corporations are cautioned that deferred compensation arrangements may create a tax problem as to the year in which expenses can be deducted.

Vacation Pay – Another area that is common to most businesses involves vacation pay. This is an amount that you pay or will pay to your employee while you are on vacation. If the employee chooses not to take vacation and you pay the amount anyway, it will be included in vacation pay. Amounts for sick pay or vacation pay are not included in vacation pay. Employers under the cash method may deduct vacation pay as wages when the employee is paid; while employers in the accrual method may deduct vacation pay in the year paid, if the amount is paid at the end of the year or within two and a half months after the close of the fiscal year. If the employer pays the amount after two and a half months after the end of the year, the amount may be deducted in the year in which it is actually paid, under the accrual method of accounting. A recent court case allowed an employer to deduct vacation pay earned in one year as long as the employer established an obligation to pay it to the employee the following year.

Miscellaneous: Employee meal and lodging expenses can be deducted only if they are considered ordinary and necessary and meet other business expense deductibility tests. The IRS has special rules for meals and lodging. Other expenses that may be deducted as compensation include money the employer pays the employee for sickness and injury, less any insurance settlement. These expenses are fully deductible for the employer and are not taxable for the employee, as long as the reimbursement plan does not discriminate in favor of the highest paid employees and involves only actual expenses.

PAYMENTS NOT IN CASH,

Employers often compensate their employees in ways other than cash. Such payments can take the form of property, shares, or directly paying an employee’s expenses. These types of expenses are considered compensation expenses and are deductible, subject to special rules. As with cash payments, there are different rules regarding the timing of these deductions.

Education Expenses: Employers may pay tuition for an employee who is taking courses that are not required for their job or are not job-related. The employer may deduct the payments as wages. However, such payments must be included in the employee’s gross income and are subject to FICA, FUTA, and withholding taxes, as are other forms of compensation. The exception to this rule is if the employer has implemented a written educational assistance plan as an additional benefit offered to employees. The IRS has the following rules for these types of plans to qualify as a tax-free fringe benefit:

• The written plan cannot discriminate between employees

• No more than five percent of the total amounts paid or incurred by the employer for assistance during the year may be provided to shareholders or owners, each of whom owns more than five percent of the employer’s stock or other capital.

• The plan cannot offer a choice between educational assistance and other compensation includable in gross income.

• The program is not required to be funded

• Employees must receive reasonable notice that the written plan exists.

The employer cannot deduct more than $5,250 per employee each year. If the plan meets all of the above rules, then the employer can deduct education expenses and does not have to include the expenses on the employee’s W-2 form. The employee does not have to take job-related courses to qualify under this exception.

In addition to the exception above, when an employer pays an employee for educational expenses in work-related courses, the employer may deduct the expenses as “non-compensatory” business expenses. This type of expense is known as a working conditions fringe benefit and is not included in the employee’s earnings.

Moving Expenses: When an employer pays for an employee to move, a deduction is allowed to reimburse the employee for certain moving expenses. There are two different types of payments for employee moving expenses: 1. The first type involves expenses that the employee can deduct when calculating their personal income tax due, and 2. The second type involves expenses that the employee cannot deduct.

The employer treats the two types of moving expenses differently. When the employee is allowed a deduction for moving expenses, the employer does not count the expense as wages. The employer reimburses the employee and takes a deduction for a normal business expense.

On the other hand, payments for moving expenses that the employee cannot deduct are considered employee income. Accordingly, payments are subject to FICA, FUTA, and employer withholding taxes. The employer must treat this expense as payment for services rendered. This way, the employer can still deduct the expense.

When an employer pays for moving expenses, the employer is required by law to give the employee a statement that describes the types of payments made on the employee’s behalf. This statement will show the employee what expenses will be included in their gross income. The IRS provides a special form for this purpose. It is up to the employer to know the basis for reimbursement of expenses to the worker for moving expenses in his personal income tax return. It is then up to the employee to declare the income and deduct the expenses on his personal tax return.

Capital Assets: A third type of payment that is not cash is the transfer of a capital asset to an employee as payment for services rendered. Employers often do this when the business is low on cash. The employer may deduct the fair market value of the asset on the date of the transfer as wages paid to an employee. The amount deducted is treated as received in exchange for the asset (as in a sale) and the employer must recognize any realized gain or loss on the transfer. The gain or loss is the difference between the fair market value of the asset and the amount the business paid for the asset, less any depreciation on the date of transfer.