Gretchen Inouye CPP, payroll consultant and the APA’s 2015 Payroll Woman of the Year, outlines the rules
Per the Internal Revenue Code (IRC), all employee compensation – which includes fringe benefits and reimbursements – is taxable income unless there is a specific exclusion in the tax code making an item nontaxable. Numerous employer-provided benefits and reimbursements are eligible for tax-favoured treatment, including total or partial exclusion from taxable income for withholding, social security, and Medicare taxes or deferral of income tax until a later date. To be nontaxable or deferrable, however, those benefits and the participants must meet requirements under the specific sections of the applicable law to be ‘qualified’.
The three most frequent basic requirements for a qualified benefit are:
- Description of the benefit plan’s provisions including eligibility, enrollment, coverage, and other rules (most plans require a written plan document).
- Communication to employees regarding the existence and operation of the benefit provisions.
- Non-discrimination in favour of highly compensated employees (HCEs) or owners.
For 2020, annual compensation of more than USD125,000 in the preceding year constitutes highly compensated or 20% of the top-paid employees. Discrimination against HCEs is not permitted.
Qualified eligibility for most employer-provided plans is restricted to employees and their beneficiaries. Former employees such as retirees or those who have been laid off may be covered.
Employers may restrict benefits to specific categories of employees. It is not uncommon to exclude part-time or temporary employees from benefit eligibility. Employers may legitimately exclude collective bargaining unit (union) employees based on contract provisions. A qualified plan may not be limited to HCEs if it is subject to nondiscrimination rules.
Enrolment rules established by the employer may include a waiting period before entrance to any plan, rules around when changes may be made, and what type – subject to IRC limitations. Qualified cafeteria plans under IRC section 125, for example, restrict employee election changes to open enrolment or listed life-event changes (temporary changes permit employees to make mid-year changes due to Covid-19).
Any business or benefit plan providing reimbursement of expenses is required to meet plan and regulatory requirements before substantiated reimbursements can be qualified as non-taxable. Substantiation includes documentation of amount, purpose, time, and place; receipts may be required. Reimbursements under various health/medical plans must be limited to medical expenses as defined by the IRC.
Qualified retirement and other deferred compensation plans must have and follow distribution rules setting restrictions around when and how employees take distributions from those plans.
Regardless of what type of employer benefit or reimbursement plan is provided and whether a plan document is required, organisations should clearly define the elements and requirements and ensure the qualifying provisions are met. Plans often require annual testing to validate that the plans meet non-discrimination rules, and corrective steps must be taken if they do not. A plan may be written to follow all the requirements, but it needs to be compliant in action as well. Records of benefits and reimbursements are subject to audit by the Inland Revenue Service and the Department of Labor. Failures to meet plan requirements can partially or completely disqualify a plan, resulting in taxable income to employees and penalties for employers.
|More information can be found in: the APA’s The Payroll Source, section 4: Health, Accident, and Retirement Benefits; and the Inland Revenue Service’s publications: 15-B (Employer’s Tax Guide to Fringe Benefits), 525 (Taxable and Nontaxable Income); and 535 (Business Expenses).|
|This article is reprinted from the August/September 2020 issue of the APA’s PAYTECH magazine.|
|The American Payroll Association (APA), www.americanpayroll.org, is the U.S. leader in payroll education, publications, and training. This nonprofit association conducts more than 300 payroll training conferences and seminars across the country each year and publishes a complete library of resource texts and newsletters. Representing more than 21,000 members, the APA is the industry’s highly respected and collective voice in Washington, DC.|
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