Business expenses are the costs a company incurs to carry out its trade, business, or profession. The IRS allows companies to deduct these expenses as long as the business tries to make a profit. In the previous chapter, the general requirements for deducting employee compensation expenses were presented. The purpose of this chapter is to present the requirements to deduct specific employee expenses. Employers will be able to use this information to decide whether a specific expense such as vacation pay, sick pay, bonuses, etc., that they incur during a year can be deducted by the company.
Employers generally provide employees with compensation in different ways. In this chapter, we will focus on both cash and non-cash payments made to employees and the deductibility of such items as business expenses.
Bonuses: The most common type of additional payment to employees takes the form of bonuses. The IRS allows you to deduct bonuses to employees if your intention is to provide the employee with additional pay for services rendered, and not as a gift. The bonus must still meet the four tests of deductibility outlined in the previous chapter. Bonuses, while deductible to the company as a business expense, are included in the employee’s income, the same as any other compensation. Bonuses simply increase the amount of total salary paid to an employee in any one year.
Gifts: Gifts that are of nominal value, such as a turkey at Christmas or other such 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 even though the company can take a tax deduction for the gift. Since such items are classified as gifts, the employee does not need to perform any services 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, no matter what the value is, and must be included in the employee’s income. Accordingly, gifts should be ‘in-kind’ items and not cash or cash equivalents.
Deferred Compensation: Some employers pay their employees a fixed amount each pay period and defer some of the total compensation until the next year.This is generally referred to as ‘deferred compensation.’ The deduction for this amount is based on the following:
1. Accrual method taxpayers can deduct the entire amount of compensation (including the deferred amount) in the year the employee performs the services for the company. This means that if the employee performed the services in one year, but the employer elected to defer the actual payment or part of the employee’s salary until the next year, the employer can still deduct the payment in year one. Such an arrangement is only allowable if a definite prior arrangement is made with the employee and the related party rules do not apply.
2. However, employers using the cash method can only deduct the amount actually paid in the year the services are rendered. Accordingly, any deferral of compensation to an employee results in a loss of a deduction to the company.
There is a special rule for accrual method taxpayers regarding related parties. Employers are not allowed to deduct payments to related taxpayers until the amount due is included in the taxpayer’s return. For this purpose, a related taxpayer includes immediate members of a family that own more than 50% of stock in the corporation. In these situations, the accrual method employer is placed on the cash basis for deducting deferred compensation. Thus, owners of closely-held companies are placed on notice that deferred compensation agreements may create a tax problem with regard to the year in which the 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 they are on vacation. If the employee chooses not to take a vacation and you pay the amount anyway, it will be included under vacation pay. Amounts for sick pay or for holiday 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 on the accrual method can deduct vacation pay in the year paid, if the amount is paid by year-end or within two and one half months after the close of the tax year. If the employer pays the amount later than two and a half months after the year ends, the amount may be deducted in the year it is actually paid, under the accrual method of accounting. A recent court case did allow the employer to deduct the vacation pay that was earned in one year as long as the employer established a liability to pay it to the employee the following year.
Miscellaneous: Expenses for meals and lodging of employees 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.The special rules were the subject of chapter one. Other expenses that may be deducted as compensation include monies the employer pays to employee for sickness and injury, minus any insurance settlement. These expenses are fully deductible to the employer and not taxable to the employee as long as the reimbursement plan does not discriminate in favor of highly paid employees and involves only actual expenses.
Employers often compensate their employees in ways other than cash. Such payments can take the form of property, stock, or by 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 are able to pay the tuition for an employee who is taking courses not required for their jobs or not otherwise job-related. The employer can deduct the payments as wages. Such payments however must be included in the employee’s gross income and are subject to FICA, FUTA, and withholding taxes, the same as other forms of compensation. The exception to this rule is if the employer has, in place, a written educational assistance plan as a fringe 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
• Not more than five percent of the total amounts paid or incurred by the employer for assistance during the year may be provided for shareholders or owners, each of whom own more than five percent of the stock or other capital of the employer
• 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 notification 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 the educational expenses and does not have to include the expenses in 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 above exception, when an employer reimburses an employee for educational expenses in job-related courses, the employer is able to deduct the expenses as “non-compensatory” business expenses. This type of expense is known as a working condition fringe benefit and is not included in the employee’s income.
Moving Expenses: When an employer pays for an employee to move, the employer is allowed a deduction for the reimbursement to the employee of certain moving expenses. There are two different types of payments for employee moving expenses: 1. The first type involves expenses that may be deducted by the employee in computing his personal income tax owed and 2. The second type involves expenses that the employee is not allowed to deduct.
The employer treats the two types of moving expenses in different ways. When the employee is allowed a deduction for moving expenses, the employer does not consider the expense to be 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 to be income to the employee. Accordingly, the payments are subject to FICA, FUTA, and withholding taxes by the employer. The employer must treat this expense as payment for services rendered. In this manner, the employer is still able to deduct the expense.
When an employer pays moving expenses, he is required by law to give the employee a statement describing the types of payments made on the employee’s behalf. This statement will show the employee which expenses will be included in his gross income. The IRS provides a special form for this purpose. It is up to the employer to know the basis of the expense reimbursement to the employee for moving expenses on his personal income tax return. It is then up to the employee to report the income and deduct the expenses on his personal tax return.
Capital Assets: A third type of non-cash payment is the transfer of a capital asset to an employee as payment for services rendered. Employers often do this when the company is short of cash. The employer is able to 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 gain or loss realized in the transfer. The gain or loss is the difference between the fair market value of the asset and the amount the company paid for the asset, minus any depreciation on the date of the transfer.