You can generally deduct the cost of providing employee compensation and benefits as a business expense.
If you have employees, you are undoubtedly aware that you can claim a business expense deduction for the wages and salaries that you pay them. However, you may not be aware that other benefits that you provide can be deducted. For example, if you give your employees a discount on the cost of your goods or services, or if you provide paid holidays or vacations, then you have provided a deductible benefit.
Employee benefits can be taxable or nontaxable
The deductibility of an expense by the employer is a different issue than the taxability of the benefit to the employees. (And in some cases, the cost to the employer and the value to the employee are not the same, at least in the eyes of the IRS.)
Some types of benefits are not taxable for payroll tax purposes. These benefits are not taxable to the employee for FICA or income tax withholding purposes, and they are not taxable to you for FICA or FUTA tax purposes.
Common examples of this type of benefit are health insurance, qualified retirement plan contributions, and group-term life insurance up to $50,000. Even if the benefit is not taxable to the employee, you can still deduct the cost of providing the benefits, provided that you meet all the requirements.
The value of fringe benefits that are not tax-free under the Internal Revenue Code must be included in the employee's taxable income. This is also true when the benefits are of a type that would be excludable if they met all the federal requirements, but for some reason, your plan does not meet the requirements.
For instance, some types of retirement plans are not permitted to discriminate in favor of highly compensated employees such as business owners. If the plans do discriminate, the value of the benefits will generally be taxable compensation to the highly compensated employees who receive them.
Again, the fact that the value of the benefit must be included in the employee's income is a separate issue than whether you can deduct the cost of providing the benefit. The cost of the benefit is still deductible by you.
For example, if you let your sales representatives use a company car, the value of this noncash fringe benefit must be included in the sales representative's wages as part of his or her compensation. You will not be able to deduct the value of this fringe benefit as a wage expense. However, you can deduct your costs of providing the cars, including the depreciation expense.
Retirement contributions may be deductible
One of the best ways to reduce your tax bill, while increasing your net worth and future security, is to invest in a retirement plan. When you own the show, you're in a position to tailor-make a plan that suits your needs precisely. If you set up a plan that meets the IRS requirements, you can make tax-deductible contributions to the plan, which will build up tax-free until you withdraw them.
As a self-employed business owner, your major retirement plan options are:
- Keogh plans. Defined benefit, defined contribution, or hybrid retirement plans set up by a self-employed person or partnership. Common types of Keoghs include money-purchase plans and profit-sharing plans.
- Simplified Employee Pensions (SEPs). A very flexible, easy plan to set up that involves making contributions to special Individual Retirement Accounts (IRAs) set up for the business owner and each eligible employee.
- SIMPLE plans. The Savings Incentive Match Plan for Employees (SIMPLE plan), which allows employees to make elective contributions of up to $12,000 in 2013 and 2014), and requires employers to make matching contributions.
- Individual Retirement Accounts (IRAs). The easiest solution to retirement savings, although your contributions are limited to $5,500 in 2013 and 2014) (Those who are age 50 and above can contribute an additional $1,000.)
Small employers with 100 or fewer employees can claim a tax credit of 50 percent of the start-up costs incurred to create or maintain a new employee retirement plan for the first three years of the plan. The amount claimed is limited to $500 in a tax year.
Reporting plan contributions varies based upon the plan
If you are a sole proprietor, contributions made for employees to a Keogh plan, a SEP, or a SIMPLE plan are reported on Line 19 of Schedule C, "Pension and profit-sharing plans." Contributions made to the plan on your own behalf would be reported on Line 28 of your Form 1040.
There are also some special tax reporting requirements with regard to the Keogh or other retirement plan itself. Generally, an annual report on IRS Form 5500-C/R (for plans with fewer than 100 participants) must be filed with the IRS by the last day of the 7th month after the close of the plan year. Single-participant plans can use Form 5500-EZ. See the instructions for these forms (available from the IRS by calling 1-800-TAX-FORM, or at its website or see your professional tax advisor.
If your IRA contribution is deductible, you don't need to file any special forms to claim it, nor do you need to itemize your deductions on Schedule A of Form 1040. Simply write the amount of your contribution (and your spouse's contribution, if married filing jointly) on Line 32 of Form 1040, or Line 17 of Form 1040A. To report any nondeductible IRA contributions, you must file IRS Form 8606, Nondeductible IRAs, with your tax return. To claim a tax credit for your retirement contributions, if you are eligible, you must file IRS Form 8880, Credit for Qualified Retirement Savings Contributions,.
Accountable plans provide significant benefits when reimbursing employees
If your employees pay business expenses from their own funds, you will generally want to reimburse them for these expenses. It is important to be aware of, and follow the rules, when making the reimbursement or you could cost yourself a business expense deduction and trigger additional income for your employees.
You will want to make sure that the reimbursements, particularly for automobile, travel, meals, and entertainment expenses, are made under an accountable plan.
Expenses reimbursed under an accountable plan are deductible as business expenses and are also excluded from the employee's gross income. If you are a sole proprietor filing Schedule C, you would deduct these reimbursed expenses in the Schedule C categories to which they pertain. So, reimbursed employee travel expenses would be added to your own travel expenses on Line 24a; reimbursed meals would be reported on Line 24b etc.
Reimbursements under a nonaccountable plan.
However, if the reimbursements are not made under an accountable plan, you must include the reimbursements in the employee's wages on IRS Form W-2. In addition, you have to withhold income taxes and employment taxes on reimbursements made, or considered made, under a nonaccountable plan and you have to pay the employer's portion of the payroll taxes.
The employee will have to report the reimbursement as income and must generally claim a miscellaneous itemized deduction for the allowable business expenses if he or she wants to get any tax benefits from them. This is a harsh result for the employee because it requires that the employee itemized deductions and the miscellaneous itemized deductions are subject to a two-percent income floor. If you are a sole proprietor, you'd include the reimbursements on Line 26 of Schedule C, "wages."
What Is an accountable plan?
Clearly, reimbursing under an accountable plan is better for both you and your employees, from a tax perspective. So, what is an accountable plan? A reimbursement arrangement that meets the following three requirements is considered an accountable plan:
- The reimbursements must be for deductible business expenses that are paid or incurred by an employee in the course of performing services for you.
- The employee must be required to substantiate the amount, time, use, and business purpose of the reimbursed expenses to you. In order to do this, the employee should submit an account book, diary, log, statement of expense, trip sheet, or similar record, supporting each of these elements, that is recorded at or near the time of the expenditure. The records should include any supporting documentary evidence, such as receipts. An employee who receives a mileage allowance is considered to have substantiated the amount of the expenses if the employee substantiates the time, place (or use), and business purpose of the travel.
- The employee must be required to return to you any excess of reimbursements over substantiated expenses within a reasonable period of time.
How long is a "reasonable period?"
The IRS will generally accept your plan if the employee is required to provide substantiation within 60 days or return unsubstantiated amounts within 120 days after an expense is paid or incurred. If you furnish your employees with periodic statements (not less frequently than quarterly) of unsubstantiated expenses, amounts substantiated or returned within 120 days of the statement will be considered returned or substantiated within a reasonable time.
You can use a mileage allowance - even one that exceeds the standard mileage rate - and if it is reasonably calculated not to exceed the employee's actual or anticipated expenses, it will be treated as meeting this return requirement even if the employee does not have to return the excess of the allowance over the standard mileage rate.
Is all this recordkeeping worthwhile?
The major financial advantage to having an accountable plan is that you are not required to pay the employer's portion of FICA taxes on reimbursements. The plan also will increase your employees' satisfaction with you because they will not have to pay taxes on the amounts or deduct them on their own tax returns.
In contrast, if you don't meet the requirements for an accountable plan, you will have to withhold income taxes and employment taxes on any reimbursements you make. While an accountable plan is not required, it could be a real money saver in the long run depending on how many employees you have and the extent to which reimbursement plays a part in your business.
Special rules apply to employer-provided meals and lodging
If you pay your employees in the form of food or housing, you can deduct your actual costs of providing these items. You would deduct them as direct costs of your business, not as employees' wages.
Example: If you are a sole proprietor and you rent a house for your temporary workers to live in, you can deduct the cost of the rental payments as "rental expenses" on Line 20b of your Schedule C, not as "wages" on Line 26.
Meals for employees.
Special, more restrictive rules for meals state that only 50 percent of the costs of meals provided to employees are deductible unless the value of the meals is included in the employees' taxable wages.
However, certain free meals provided to employees for the convenience of the employer are 100 percent deductible by the employer and are not taxable to the employees. To be considered "for the convenience of the employer," they must be taken on the business premises.
You can deduct the full cost, not just 50 percent, of providing an occasional social or recreational events for your employees, such as a company picnic or holiday party.
If an employer provides meals to its employees on the premises and more than one-half of the employees are receiving the meals "for the convenience of the employer," the meals will not be taxable to any of the employees and the employer can deduct the entire cost of all the meals. The question of exactly what "convenience of the employer" means remains an unsettled question in the law. Generally, if your employees must remain on the premises in order to be available to work if needed, or if the lunch breaks are too short to allow employees to go out to eat, the meals would be considered to be for the employer's convenience.