Shareholder Fringe Benefits - Overview

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As we approach the end of the year it’s important for companies to understand the proper reporting of fringe benefits paid to employees during the year to ensure compliance with rules and regulations and to correctly report the information to its employees. Many companies may be unaware that fringe benefits are reported differently for employees than they are for partners of a partnership and greater than 2 percent shareholders of an S-corporation. While the Internal Revenue Code (IRC or Code) generally allows employees to exclude fringe benefits from gross income, this same benefit may not be allowed for partners in a partnership because the Code treats partners as self-employed individuals and not employees of the partnership. Therefore, since a self-employed individual would need to include any fringe benefits paid on their behalf in gross income under IRC § 61(a)(1), any partner that is treated as self-employed for purposes of determining the taxability of fringe benefits must also include those fringe benefits in gross income. However, for other fringe benefits, the Code specifically treats partners as employees of the partnership, allowing the partners to exclude those benefits from income [IRC 401(c)(3)].

Under IRC § 1372, any S-corporation shareholder owning (directly or indirectly) a greater than 2 percent interest is treated like a partner in a partnership for determining the taxability of fringe benefits paid on their behalf. However, the reporting of these fringe benefits might be different, because of the different ways partners and S-corporation shareholders are compensated. In this article we will use the term “greater than 2 percent shareholders” to mean both greater than 2 percent shareholders in S-corporations and partners in a partnership. Differences in reporting will be highlighted where applicable.

This article will examine common fringe benefits offered to employees, classifying them as either nontaxable or taxable fringe benefits, and will describe how each benefit should be properly reported on the corporation’s tax return and on the related employee’s tax return.

Taxable Fringe Benefits

Unless otherwise identified as a nontaxable fringe benefit under IRC  §401 (discussed later) all fringe benefits provided to greater than 2 percent shareholders are considered taxable for federal income tax purposes. This simply means the individual must include the fringe benefits paid on their behalf in gross income. The most common taxable fringe benefits are:

  1. The cost of group-term life insurance, up to $50,000 (IRC §79).
  2. The amounts paid for or to an accident or health plan (IRC §105 and 106).
  3. Meals & Lodging furnished for the convenience of the employer (IRC §119).

Group-Term Life Insurance

Under IRC §79(a), employees may exclude from income the premiums paid on their behalf for the first $50,000 of group-term life insurance coverage. However, this benefit does not apply to greater than 2 percent shareholders; these individuals must include the entire amount of group-term life insurance premiums paid on their behalf into gross income. These payments should be included in line 1 of a greater than 2 percent shareholder’s W-2, subject to regular federal withholding. This additional compensation is also subject to employment tax withholding (FICA and FUTA).

Regardless of the taxability of the life insurance premium payments to the employee, the corporation will be able to deduct the cost of providing life insurance to all its employees. However, the payments may need to be reported on a different line on the corporate tax return. If the life insurance premiums were included in gross income of an employee because they were a greater than 2 percent shareholder then the amount may be deductible as officer’s compensation, salaries and wages or guaranteed payments, depending on the type of entity and employee’s role. Alternatively, it could be included on the corporation’s tax return as an employee benefit program expense if the life insurance premiums were excluded from income by the employee. In any case, there is no deduction on the individual’s tax return for life insurance premiums paid as there is for accident or health insurance (described in the next paragraph).

Businesses which have company owned life insurance policies on their employees for which the company is the beneficiary should be aware of the filing and record keeping requirements associated with IRC § 6039I

Health Insurance

Generally, employees may exclude from gross income the amount of health insurance premiums paid on their behalf (and on behalf of their spouse and dependents) by their employer. However, greater than 2 percent shareholders must include the same amount into gross income because they are not considered employees under IRC §1372. For shareholders who must report health insurance premiums in gross income, this amount should be included in box 1 (and likely box 16 and 18 if applicable) of their W-2, subject to regular federal withholding. However, assuming the payments of insurance premiums are made pursuant to a plan (discussed later), these payments are not subject to employment tax (FICA and FUTA) withholding. Additionally, the amount of insurance premiums paid on the greater than 2 percent shareholder’s behalf should be reported on line 14 of the individual’s W-2.

For partners in a partnership, health insurance paid on the partner’s behalf must be included in guaranteed payments on line 4 of the partner’s schedule K-1. It is also reported on line 13 (Code M) of the partner’s K-1.

Although greater than 2 percent shareholders must include this amount in gross income, they may be eligible for an above-the-line deduction on their individual tax return, effectively eliminating the additional income they had to pick up in income. The payment of health insurance benefits made by the employer is treated as if the shareholder made the payment personally. Therefore, the total deduction for health insurance is calculated as the combination of health insurance premiums paid by the shareholder personally, and those premiums paid by the shareholder’s employer on their behalf. Any payments made on behalf of the shareholder’s spouse and dependents are also included in this deduction. However, this deduction has two limitations:

  1. The deduction is not available for months in which the 2 percent shareholder or spouse is eligible to participate in another subsidized health insurance plan offered by any other employee of the taxpayer, taxpayer’s spouse or dependents.
  2. The deduction may not exceed the taxpayer’s earned income derived from the trades or business that provides the health insurance plan. For S-corporation shareholders, this amount is equal to the Medicare wages listed on the shareholder’s W-2 [IRC Sec. 162(l)(5)].

Assuming the greater than 2 percent shareholder or spouse participates in another health insurance plan, the taxpayer and spouse may not claim the health insurance premiums as an above-the-line deduction. Rather, they would have to report them on Schedule A as an itemized deduction, subject to the 7.5 percent AGI limitation for medical expenses.

The amount of premiums paid by the corporation on the shareholder’s behalf will be deductible by the corporation as either officer’s compensation, salaries and wages or guaranteed payments, depending on the type of entity and individual’s role in the company.

Short- and Long-Term Disability Insurance

For purposes of determining the taxability of short- and long-term disability insurance premiums paid on behalf of an employee, shareholders who own greater than 2 percent of an S-corporation are treated as self-employed. Therefore, any disability insurance premiums paid on their behalf must be included in the shareholder’s gross income. However, please note that there is not a related deduction on the shareholder’s individual tax return for disability insurance premiums paid by the employer or by the shareholder personally as there is for health insurance. Assuming the payments of short- and long-term disability insurance premiums are made pursuant to a plan, these payments are not subject to employment tax withholding (FICA and FUTA).

The corporation may claim a compensation deduction for any amount of disability insurance payments made on behalf of a greater than 2 percent shareholder. Regular employees and individual shareholders who own less than 2 percent in an S-corporation are able to receive tax-free disability insurance coverage, the cost of which is deductible by the corporation as an “employee benefit programs” expense.

Health Savings Accounts (HSAs)

An employee is eligible to contribute to an HSA if he or she is 1) covered by a high-deductible health plan (HDHP) and 2) not covered under any other health plan. Employers are able to contribute to an eligible employee’s HSA account. Employer’s contributions made on behalf of employees who are less than 2 percent shareholders are excluded from the employee’s income.  Employer contributions to a HSA are reported on form W-2 in box 12 with code W.   However, this same benefit is not afforded to greater than 2 percent shareholders. Any HSA contribution made by the company on a greater than 2 percent shareholder’s behalf must be included in the shareholder’s gross income. Although this additional income is subject to regular federal withholding taxes, it is not subject to FICA and FUTA withholding taxes [IRC  §  ok – leave in]. Regardless of the taxability to the employee/shareholder, the company can deduct the contribution made to the employee’s HSA as either a compensation expense or an employee benefit expense, as long as the contributions are comparable for all employees who have comparable coverage, ie: the contributions are nondiscriminatory  [IRC  § 4980G]. 

Any HSA contributions, whether made by the employer or the employee, may be deductible as an “above the line” deduction on the employee’s Form 1040, line 25.  In a situation where the employer’s contribution to an individual’s HSA is not included in gross income, the same individual cannot deduct the contribution made by the employer as an “above the line” deduction. However, that individual can deduct any contribution made to their HSA personally. In the case of a greater than 2 percent shareholder, where the employer’s contribution is included in the gross income, the shareholder can deduct the employer contribution (as if the contribution was made by the shareholder personally) as well as any contribution made personally.

The maximum HSA contribution for 2014 is $3,300 for an individual with self-only coverage or $6,550 for an individual with family coverage (Rev. Proc. 2013-25).  Limits for 2015 are $3,350 and $6.650, respectively (Rev. Proc. 2014-30).  For individuals over age 55, an additional contribution of $1,000 is allowed. It should be noted that no contributions can be made to an individual’s HSA after he or she becomes enrolled in Medicare Part A or Part B.   

Provided distributions from an HSA are used for qualified medical expenses, the distributions are not taxable income.  However, there is no requirement that distributions be taken in the year the contributions are made.  Therefore, it is possible for HSA accounts to receive qualified contributions and use other funds to pay medical expenses thus allowing these funds to grow tax deferred until such time as they are needed.  In addition, while contributions can no longer be mailed once the individual becomes Medicare enrolled, the funds can be distributed to cover any qualified medical costs not covered by Medicare.

Medical Savings Accounts (MSAs)

Employer contributions to an employee’s MSA is treated the same as contributions made to an employee’s HSA. Employees who do not own more than 2 percent of the S-corporation may exclude from income any employer contribution made to their MSA; however, greater than 2 percent shareholders must include in income any MSA contribution made by the employer. For MSA contributions that must be included in income, the employer’s contribution should be reported on the employee’s W-2 in box 12, with code R. Although this additional income is subject to regular federal withholding taxes, it is not subject to FICA and FUTA withholding taxes [IRC  § 3121(a)(2) and 3306(b)(2)].

Since the contribution is included in gross income by a greater than 2 percent shareholder, the company takes a compensation expense deduction. If the amount paid to an employee’s MSA is not included in that employee’s income because they do not own more than 2 percent of the company, that amount is deducted on the corporation’s tax return as an employee benefit expense. Additionally, any MSA contribution, whether made by the employer or the employee, may be deductible on the employee’s Form 1040 as an “above the line” deduction on line 35. IRS Form 8853 is used to calculate this deduction.

Cafeteria Plans

A cafeteria plan is a separate written plan maintained by an employer meeting the regulations of Section 125 of the IRC. It provides participants an opportunity to choose from a menu of cash and qualified benefits. Employees can contribute an amount for certain qualified benefits on a pretax basis, which escapes federal income tax and social security and Medicare (FICA) taxes. The deductibility of contributions and the amount of the deduction is based on the code section which governs each specific fringe benefit in the plan. However, the benefit of contributing an amount pretax is only available to employees. For cafeteria plans, greater than 2 percent shareholders are not considered employees and, thus, not able to participate in a cafeteria plan [Prop. Reg. 1.125-1(g)(2); IRC Sec. 401(c) and 1372]. Additionally, the attribution rules of IRC Sec. 318 apply in determining who is a greater than 2 percent shareholder. Therefore, a spouse, child, grandchild, or parent of a greater than 2 percent shareholder are considered self-employed and cannot participate in a cafeteria plan. If any 2 percent shareholder, or related party under IRC Sec. 318, participates in the cafeteria plan, that plan is no longer a qualified cafeteria plan. Therefore, employees cannot make pretax contributions to obtain any benefits offered under the plan.

In determining who is a partner in a partnership (or member of an LLC taxed as a partnership), the attribution rules of IRC Sec. 318 do not apply. Therefore, a spouse, child, grandchild, or parent of a partner or LLC member may participate in a cafeteria plan without disqualifying the plan, as long as the individual is a bona fide employee of the partnership or LLC.

Meals & Lodging

Under IRC §119, the fair market value (FMV) of meals and/or lodging furnished to an employee, or the employee’s spouse or dependents for the convenience of the company, is excluded from the employee’s gross income.

However, this same benefit is not granted to greater than 2 percent shareholders. The FMV of meals and/or lodging for the convenience of the employer furnished to a greater than 2 percent shareholder must be included in gross income, subject to regular federal withholding taxes, as well as employment tax withholding (FICA and FUTA).

Other Taxable Fringe Benefits

  • Employee Achievement Awards [IRC §74(c)]
  • Qualified Transportation Fringe Benefits [IRC §132(f)]
  • Qualified Moving Expense Reimbursement [IRC §132(g)]
  • Adoption Assistance Programs [IRC §137]

While the above items can, subject to certain limitations, qualify for non-taxable status for employees and less than 2% shareholders, they are explicitly taxable to a more than 2% shareholder of an S-corporation.

Tax Treatment of Taxable Fringe Benefits

All taxable fringe benefits should be recorded by the company as a compensation expense. Generally, under IRC §3121(a)(20) and 3306(b)(16), all taxable fringe benefits treated as compensation are subject to employment taxes (FICA and FUTA). However, there is an exception under IRC §3121(a)(2) and 3306(b)(2) for the payment of insurance premiums for which are made pursuant to a plan (see below) and are not subject to employment taxes. The insurance premiums that qualify for this exception are accident and health insurance, short- and long-term disability insurance, and life insurance (not including group-term life insurance). According to Rev. Rul. 80-303, payments of insurance premiums are made pursuant to a plan if any of the following apply:

  1. The plan is in writing or otherwise made known to employees.
  2. There is reference to the plan in the employment contract.
  3. Employees contribute to the plan.
  4. There is a separate fund for payments apart from the employer’s salary account.
  5. The employer is required to make the payments.

Nontaxable Fringe Benefits

IRC § 401(c)(1) treats certain self-employed individuals as employees. Thus, in determining the taxability of certain fringe benefits, greater than 2 percent shareholders are treated as employees of the company. Thus, the following fringe benefits may be excluded from an employee’s income, regardless of whether or not the employee is a greater than 2 percent shareholder. These fringe benefits are called nontaxable fringe benefits and may be excluded from gross income:

  1. Qualified Retirement Plans
  2. Educational Assistance Programs [IRC §127].
  3. Dependent-Care Assistance Programs [IRC §129].
  4. Qualified Employee Discounts, no-additional cost services, working condition fringes, on-premises athletic facilities, de minimis fringes, and retirement planning services [IRC §132].

Any amount paid to an employee’s retirement plan is reported on the corporation’s tax return on page 1, line 17, of Form 1120S (“Pension, profit-sharing, etc., plans”). All other nontaxable fringe benefits paid on behalf of its employees (including 2% shareholders) are reported on page 1, line 18 of Form 1120S (“Employee Benefit Programs”). There is no additional required reporting to shareholders on their K-1s for nontaxable fringe benefits.

Attached to the end of this article is a table that summarizes the various types of fringe benefits that are not subject to federal income tax withholding, and are in most cases also exempt from employment taxes.  Please note that the taxability of these fringe benefits varies depending on if the employee is a 2 percent shareholder. 

Table 2-1. Special Rules for Various Types of Fringe Benefits

(For more information, see Publication 15-B Employer’s Tax Guide to Fringe Benefits 2014.)

Treatment Under Employment Taxes

Type of Fringe Benefit

Income Tax Withholding

Social Security and Medicare (including Additional Medicare Tax when wages are paid in excess of $200,000)

Federal Unemployment (FUTA)

 

Accident and health benefits

Exempt1,2, except for long-term care benefits provided through a flexible spending or similar arrangement.

Exempt, except for certain payments to S corporation employees who are 2% shareholders.

Exempt

Achievement awards

Exempt1 up to $1,600 for qualified plan awards ($400 for nonqualified awards).

Adoption assistance

Exempt1,3

Taxable

Taxable

 

Athletic facilities

Exempt if substantially all use during the calendar year is by employees, their spouses, and their dependent children and the facility is operated by the employer on premises owned or leased by the employer.

De minimis (minimal) benefits

Exempt

Exempt

Exempt

Dependent care assistance

Exempt3 up to certain limits, $5,000 ($2,500 for married employee filing separate return).

Educational assistance

Exempt up to $5,250 of benefits each year.

Employee discounts

Exempt3 up to certain limits.

Employee stock options

See Publication 15-B Employer’s Tax Guide to Fringe Benefits 2014

Employer-provided cell phones

Exempt if provided primarily for non-compensatory business purposes.

 

Group-term life insurance coverage

Exempt

Exempt1,4, 7 up to cost of $50,000 of coverage. (Special rules apply to former employees.)

Exempt

Health savings accounts (HSAs)

Exempt for qualified individuals up to the HSA contribution limits.

Lodging on your business premises

Exempt1 if furnished for your convenience as a condition of employment.

 

Meals

Exempt if furnished on your business premises for your convenience.

Exempt if de minimis.

Moving expense reimbursements

Exempt1 if expenses would be deductible if the employee had paid them.

No-additional-cost services

Exempt3

Exempt3

Exempt3

Retirement planning services

Exempt5

Exempt5

Exempt5

 

Transportation (commuting) benefits

Exempt1 up to certain limits if for rides in a commuter highway vehicle and/or transit passes ($130), qualified parking ($250), or qualified bicycle commuting reimbursement6 ($20).

Exempt if de minimis.

Tuition reduction

Exempt3 if for undergraduate education (or graduate education if the employee performs teaching or research activities).

Working condition benefits

Exempt

Exempt

Exempt

1 Exemption does not apply to S corporation employees who are 2% shareholders.

2 Exemption does not apply to certain highly compensated employees under a self-insured plan that favors those employees.

3 Exemption does not apply to certain highly compensated employees under a program that favors those employees.

4 Exemption does not apply to certain key employees under a plan that favors those employees.

5 Exemption does not apply to services for tax preparation, accounting, legal, or brokerage services.

6 If the employee receives a qualified bicycle commuting reimbursement in a qualified bicycle commuting month, the employee cannot receive commuter highway vehicle, transit pass, or qualified parking benefits in that same month.

7 You must include in your employee's wages the cost of group-term life insurance beyond $50,000 worth of coverage, reduced by the amount the employee paid toward the insurance. Report it as wages in boxes 1, 3, and 5 of the employee's Form W-2. Also, show it in box 12 with code “C.” The amount is subject to social security and Medicare taxes, and you may, at your option, withhold federal income tax.

 

We have reviewed only some of the many fringe benefits offered to employees today. For more information contact your Dixon Hughes Goodman tax advisor or:

Christopher Liebner | 703.226.0042 | christopher.liebner@dhg.com

 

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