Trade or business expenses are
allowed as a deduction against business income only if they meet the
ordinary and necessary expense rules of IRC §162. Section 162 applies to
all businesses including partnerships and corporations. A necessary and ordinary expense that
benefits an employee of the business will also be deductible by the
business, even if the employee benefit is excluded from the employee’s
taxable income.
Employee Benefits
A fringe benefit is any compensation or
other employee benefit that is not in the form of cash.
Some employee benefits may be excluded from the employee’s gross income
and therefore are not subject to income tax. Other employee benefits are
taxable to the employee. Employee benefits are excludable from income only
if so specified by the tax code.
From the perspective of an owner who is
also an employee of a business entity, an employee benefit will generally
provide two favorable tax benefits. The employee benefit is tax deductible
by the business that pays the expense, and tax free or tax deferred to the
employee that receives the benefit. For employment tax purposes, a
shareholder performing services for his/her corporation is considered an
employee; whereas a partner or a self-employed individual is not
considered an employee. For employee benefit purposes, the same is generally
true except for several specific exceptions.
S Corporation Shareholders: For
employee benefit purposes, an S corporation is treated as a partnership; and
a greater than 2% shareholder is treated as a partner rather than an
employee. The term "greater than 2% shareholder" includes
individuals that are considered to indirectly own stock under the
constructive ownership rules of IRC §318 (such as spouse, parents,
children, and grandchildren of stockholder). [IRC §1372]
Employee benefits subject to these rules
include:
• Cost of an accident and health plan.
• Cost of up to $50,000 of group-term life insurance on an employee’s
life.
• Cost of meals and lodging furnished for employer’s convenience.
Inclusion In Income: An S
corporation that pays any of the above expenses for the employee benefit of a more
than 2% shareholder must add the cost to the employee/shareholder’s
gross wage [Rev. Ruling 91-26]. The employee/shareholder must pay income
tax on the employee benefit, and the S corporation is allowed a tax deduction for
wages paid. If the requirement for exclusion under IRC §3121(a)(2)(B) is
satisfied, these payments are not wages for Social Security and Medicare
tax purposes even though included for income tax purposes.
Partnerships have two choices:
1) If the payment of the employee benefit expense is for the
benefit of a partner performing services for the partnership, then the
employee benefit
expense is considered a guaranteed payment to the partner, and deductible
by the partnership as such. The payments will not reduce the partner’s
capital account.
2) If the employee benefit expense payments are paid based on the
profits of the partnership and not on services rendered by the partner,
the employee benefit expenses are considered a reduction in distributions to the partner
and are not deductible as an employee benefit expense by the partnership.
Advantages To Both Employee And Employer
Employee benefits can provide tax savings for
both the employer and employee.
Nondiscrimination Rules
The nondiscrimination rules are designed to
prevent employers from discriminating in favor of owner-employees or other
key personnel. If an employee benefit plan is offered to every employee,
the plan is generally not considered a discriminatory plan. If the employee benefit plan is
only offered to certain highly compensated or key employees, the employee benefits
may be taxable to those employees.
