Federal and state payroll tax laws generally identify taxable compensation as being an employee's wages and broadly define "wages" to encompass virtually every payment to an employee for services rendered. Whenever you transfer something of value to an employee as compensation for the employee's services, you've potentially made a taxable wage payment.
You should assume that all compensation you pay to employees is taxable wages unless you're aware that the law exempts a given payment from taxation. Let's look at some examples that might arise in your business.
Advances. Payments you make to your employees for services they'll perform or complete in the future are taxable wages for payroll tax purposes. Advances aren't taxable wages if the employees are legally obligated to repay the advanced amounts. Advances to employees to cover expenses they'll incur in performing services for you aren't taxable wages if they're made under an accountable plan.
Gifts. Most gifts that you give to your employees are presumed to be compensatory in nature. Unless you can show that a gift is connected with an event that's totally unrelated to your business (for example, an employee's wedding), gifts to your employees are considered taxable wages for payroll tax purposes. Christmas gifts aren't considered taxable wages if the gifts are items of property having nominal value (for example, a turkey or a ham). Small gifts of cash don't qualify for the exception.
Prizes and awards. Employee prizes and awards also are generally considered taxable wages, but a noncash prize or award isn't taxable if the value is no more than $400 and it's given to an employee as a length-of-service or safety-achievement award.
Business expense reimbursements. In general, unless you make advances and reimbursements under an accountable plan, they are included in taxable wages. An accountable plan is one that meets these requirements: (1) The reimbursements must be for your deductible business expenses that are paid by an employee in the course of performing services for you; (2) The employee must be required to substantiate the elements of amount, time, use, and business purpose; and (3) The employee must be required to return to you any excess of reimbursements over substantiated expenses within a reasonable period of time.
Fringe benefits. The value of all fringe benefits not specifically excluded by the tax laws are considered taxable wages for payroll tax purposes, and you may have to withhold and pay the taxes on the basis of the fringe benefits' fair market value. However, the law does include a rather lengthy list of fringe benefits that you can provide your employees without incurring any FICA or FUTA tax obligations. For the most part these fringe benefits are also excluded from an employee's income for income tax purposes.
Some examples of benefits that are excluded from taxable wages are health plan payments, employer's contributions to a qualified pension or retirement plan, worker's compensation premiums and benefits, and benefits that have minimal value, such as occasional parties, occasional supper money or taxi fares when an employee works late, coffee and donuts, occasional tickets to entertainment or sporting events, use of company telephone or copy machines for personal purposes, etc.
Jury duty pay. Amounts you pay your employees while they're serving on jury duty are considered taxable wages for payroll tax purposes, even though the payments may be for periods when the employees are absent from work. However, the taxable amount will differ depending on how you treat your employees' jury duty pay. If you reduce regular wages by jury duty pay, payroll taxes apply to the reduced wage amount. If you pay the regular wage, but require employees to give jury pay to you, payroll taxes apply to the regular wage amount reduced by the jury duty pay. If you pay the regular wage and allow employees to keep jury pay, payroll taxes apply to only the regular wage amount.
Tips and gratuities. Cash tips that your employees receive from your customers may constitute taxable wages for payroll tax purposes. In contrast, non-cash tips, such as theater tickets, are never considered wages. Tips are payments that customers make without compulsion and with the unrestricted right to determine the amount. For example, suppose you operate a restaurant and include a mandatory gratuity of 17% on the check of parties of eight or more. You distribute these amounts to your employees. This isn't a tip, it's a service charge and it constitutes taxable wages upon its distribution to the employees.
Vacation pay. If you've extended your employees the benefit of paid vacation time, the amounts you pay them while they are on vacation are considered taxable wages, notwithstanding that the payments are for periods when the employees are absent from work. Furthermore, it shouldn't be at all surprising that the same rule applies to your payments to employees who don't take their vacations and instead receive additional amounts for the time they could have taken off.
Noncash wages. One of the first issues you'll need to consider if you choose to provide employees with taxable fringe benefits, lodging, equipment, or other noncash items is determining how much you paid. For noncash payments, the amount of taxable wages is the fair market value of the benefits or property at the time of payment. In general, "fair market value" is the amount an individual would pay an unrelated third party to obtain comparable benefits and property.
Perhaps the biggest problem with paying an employee noncash wages is that you must see to it that the income taxes and FICA taxes that you're required to withhold with respect to the payments are available for collection. If you also pay the employee cash wages, you can withhold all the required taxes from the cash remuneration. If you don't pay any cash wages or if the cash wages you pay are insufficient to cover all of the withholding taxes, you must try to get the necessary funds from the employee. Unfortunately, this is frequently easier said than done.
Payments for casual labor. Occasionally, you may pay workers to do work that doesn't promote or advance your business. For example, during a slow business period you may pay an employee to do some work around your home. Or you may pay one of your computer technicians to set up your personal home computer. Unless certain dollar thresholds are met, your payments to those employees will not constitute taxable wages for payroll tax purposes. Furthermore, noncash payments for casual labor will never be taxable.
