Tax-saving Employee Benefits that Can Help Employers
HR leaders often find that effective recruitment and employee retention are among their top challenges. In fact, the 2020 Paychex Pulse of HR Survey found that HR teams are looking for technology and tools to help them reach quality candidates who not only fit company culture, but who are also willing to stay with the organization.
Given these types of challenges, how can you retain valued workers and attract new ones? Companies competing for talent must offer not only competitive pay but also attractive employee benefits, even if they entail tax costs to employees and the company. Benefits can help attract and retain good employees and can potentially cut down on the costs of finding and training new workers. Many also come with tax-saving benefits.
Overview of tax savings on benefits
Just like wages, salary, commissions, and bonuses you pay to your staff, the cost of employee benefits is tax-deductible. In addition, there can be employment tax savings. If you raise employees' compensation instead of offering benefits, the additional compensation costs you employment taxes.
More specifically, you pay 6.2 percent for Social Security taxes on compensation up to the annual wage base ($142,800 in 2021). You also pay 1.45 percent in Medicare taxes on all compensation. But many types of employee benefits are treated as tax-free compensation and are exempt from Social Security and Medicare (FICA) taxes.
What is FICA tax?
The Federal Insurance Contribution Act (FICA) tax is a federal payroll tax paid by employees and their employers that consists of a Social Security tax and Medicare tax. The FICA tax rate is applied to all taxable compensation, including salary, wages, tips, bonuses, commissions, and taxable fringe benefits.
Benefits that are exempt from FICA
Two of the most popular tax-exempt employee benefits — health insurance and employer contributions to qualified retirement plans — are not subject to FICA. But these aren't the only benefits that can be offered free from FICA tax. Per the Internal Revenue Service (IRS), tax-deductible employee benefits include:
- Achievement awards: Awards you give to employees for length of service are exempt from FICA up to a set dollar limit ($1,600 for qualified plan awards; $400 for nonqualified awards).
- Cell phones: As long as the primary reason for providing the phones to employees is for business and not merely as compensation, then this cost is exempt.
- De minimis fringe benefits: Coffee in the break room, an occasional taxi ride home at night, and flowers for a personal occasion are examples of de minimis benefits that are exempt, but cash (including gift cards) in any amount is taxable.
- Dependent care assistance: Employer-paid assistance is exempt up to $5,000 annually ($10,500 for 2021, as part of the American Rescue Plan Act).
- Educational assistance: Non-job related assistance is exempt up to $5,250 each year. If the courses are job-related, then there's no dollar limit on the amount that is exempt.
- Group-term life insurance: The cost of coverage up to $50,000 is exempt. Coverage for a spouse or dependent is exempt only up to $2,000.
- Health savings accounts (HSAs): Employer contributions to employees' accounts are exempt up to the dollar limit per year. (In 2021, it's $3,600 for self-only coverage and $7,200 for family coverage under a high-deductible health plan to a qualified individual's HSA).
- Meals and lodging: The value of providing these taxable benefits on company premises for the convenience of the employer is exempt.
- Retirement planning services: The cost is exempt from FICA. However, tax return preparation costs, which may be a benefit for executives and managers, is not.
- Transportation benefits: The costs for parking, transit passes, and van pooling are tax-free up to a set monthly limit ($270 in 2021).
Benefits that are not exempt from FICA
While there are many benefits that can be offered to employees that are exempt from FICA tax, there are some that are not tax-deductible. For example, adoption assistance, which is tax-free to employees up to a set dollar amount each year ($14,440 in 2021), is still subject to FICA. Additionally, for tax years beginning after 2017 and before 2026, moving reimbursements are no longer tax-deductible, per the Tax Cuts and Jobs Act.
Special concerns for S corporation owner-employees
While shareholders of S corporations who work in their companies are employees, they cannot enjoy the same benefits in all cases. Here are some exceptions that apply to shareholders owning more than 2 percent of the stock:
- Achievement awards are not tax-free to the shareholder-employees and are not exempt from FICA.
- Group-term life insurance cannot be used as a tax-free fringe benefit to owner-employees. They are treated as a partner in a partnership for purposes of this fringe benefit. Thus, the benefit is treated as taxable compensation subject to FICA.
- Health insurance must be included in a shareholder-employee's compensation. They can deduct the premiums as an adjustment to gross income on Form 1040. However, the coverage is exempt from FICA.
- Health savings account contributions are treated as distributions.
- Meals and lodging for an owner-employee on company premises are not tax-free benefits.
- Moving reimbursements are not tax-free benefits exempt from FICA.
- Transit passes treated as tax-free are capped at $21 per month. If the cost exceeds $21, then the full amount is taxable.
The value behind offering a taxable fringe benefit
If you offer taxable fringe benefits to an employee, there is still considerable value in offering them. The cost to the employee for receiving a taxable benefit is considerably less than what it would cost the employee to pay out-of-pocket for it. For example, say you pay $1,000 toward an employee's student loan debt. If the employee is in the 22 percent tax bracket, this benefit costs the employee $220 in income taxes and $76.50 in FICA taxes, or a total of $296.50. If the employee wanted to pay the same $1,000 out-of-pocket, they would have to earn an additional $1,425 to come out the same.
Which fringe benefits should a business offer?
Despite the income tax cost to employees (and the added payroll tax cost to employers), certain fringe benefits are taxable, so your offering is limited only by your imagination and your budget. Here are some of the employee tax deductions you might want to consider:
- Student loan repayment assistance: This benefit can be particularly attractive for millennial and Gen Z workers.
- Moving expenses: Because the cost of assistance to employees who relocate is no longer tax-free to employees or deductible by employers, any assistance you choose to offer to defray the cost of moving household items is considered additional taxable compensation.
- Commuter benefits: Employers cannot deduct the cost of free parking, transit passes, or vanpooling, but employees can receive these benefits tax-free up to $270 per month in 2021. This means the benefits are not subject to payroll taxes. For 2018 through 2025, the former tax-free monthly amount of $20 ($240 per year) for bicycle commuting is not tax-free (except where necessary for the employee's safety).
- Excess mileage reimbursements: If you reimburse employees for driving their personal vehicles on company business under an accountable plan using the IRS rate but pay the employee more than the rate, the excess amount is taxable. For example, in 2021 when the IRS rate is 56 cents per mile, if you reimburse the employee at the rate of 60 cents per mile, then each mile triggers four cents of taxable compensation to the employee.
- Education assistance over the $5,250 annual limit: If you have a nondiscriminatory education assistance plan and cover more than $5,250 of an employee's costs that aren't job-related, the excess is taxable to the employee.
- Personal use of a company vehicle: There are a variety of ways to figure the taxable amount of this fringe benefit; see IRS Publication 15-B.
Because these benefits are taxable compensation to employees (other than where noted), they are subject to payroll taxes. For example, there's a 7.65 percent FICA cost to employers on these benefits. Be sure to also factor in any state-level payroll costs (e.g., unemployment tax, workers' compensation, etc.).
If the taxable fringe benefits are merely cash payments, then lump the payments in with regular compensation and withhold accordingly. If the taxable fringe benefits are not in cash (e.g., personal use of a company vehicle), then special rules come into play that provide you with considerable flexibility in handling payroll taxes.
You can treat taxable non-cash fringe benefits as paid on a pay period, quarter, semiannual, annual, or other basis, as long as they're treated as paid no less frequently than annually. You don't have to choose the same period for all employees; you can withhold more frequently for some employees than for others. You can also change the period as often as you want or need to do, as long as you treat all of the benefits provided in a calendar year as paid no later than Dec. 31.
You can even treat the value of a single fringe benefit as paid on one or more dates in the same calendar year, even if the employee receives the entire benefit at one time. You don't have to notify the IRS of the use of different pay periods.
Example: Your employee receives a fringe benefit valued at $1,000 in one pay period during 2021. You can treat it as made in four payments of $250, each in a different pay period of 2021.
When it comes to withholding on non-cash fringe benefits, which are viewed as supplemental wages, you have a choice:
- Withhold income taxes at a flat 22 percent rate (a 37 percent rate applies only when supplemental wage payments to an employee exceed $1 million in the year).
- Add the value of the supplemental wages to regular compensation and then figure withholding on the total amount.
You also have to withhold FICA on supplemental wages.
Before you start expanding your menu of benefits, consider surveying employees to learn what they really want. It may turn out that benefits such as a long-term flexible work schedule, which is no cost you or your staff, is particularly valuable to them.
Common and commonly overlooked tax deductions
Even experienced small-business owners can face financial challenges at some point during the lifetime of their company. One way to help offset costs is by uncovering qualifying business tax deductions. Companies leave billions of tax credit dollars unclaimed each year due to not knowing they qualified, or not having the experience or time to handle the administration involved. To help remedy this, it's important to be aware of which ones you qualify for as well as the requirements for eligibility. You may not know it, but there could be money out there waiting for your business to claim in time for tax filing season.
Here are some common tax deductions that are available to qualifying businesses:
- Federal Work Opportunity Tax Credit: Employers who hired qualified employees could qualify for this deduction. It's typically 40 percent of the first $6,000 paid to each of the qualifying employees during the first year of employment. Employers who hire qualified veterans could see a credit of up to $9,600.
- Healthcare tax credits: As part of the Affordable Care Act, qualifying businesses with less than 25 full-time equivalent employees can deduct up to half of their contributions toward employees' health insurance premiums (up to 35 percent for tax-exempt employers), as long as they offer coverage through the Small Business Health Options Program.
- Section 179 expensing and bonus depreciation: Your company can deduct the full cost of qualifying equipment (new or used), up to $1,050,000, and a value of property purchased to $2,620,000 from your 2021 taxable income.
- Retirement plan expenses: Tax benefits are available when you establish a retirement plan for you and your employees. First, you could receive deductions for plan contributions that you put on your personal income tax return. Additionally, costs associated with establishing a plan are deductible by up to 50 percent (up to $500 per year) during the first three years of plan implementation.
- Expenses for going into business: Current business expenses such as advertising, transportation, facilities, and fees for consultants can be deducted. To get a business up and running, capital expenses can be deducted up to $5,000 the first year you are in business.
Other common deductions for business owners can include home office expenses, business-related software and subscriptions, business use of a cell phone and car, and legal expenses.
At the state level, many states also offer tax credits for businesses that create jobs, conduct research and development, or make certain investments. A tax professional who is familiar with credits at the state level can help ensure you are identifying all of the deductions your business can take.
The items listed above don't make an exhaustive list of tax-saving business deductions. Organizations can use professional tax services to discover additional tax credit opportunities, feel more confident about determining their eligibility for tax deductions, and claim credits. Maintain proper records and take advantage of tax professional services to help you maximize your filing and ensure you don't miss any commonly missed tax deductions.