Employment Law 101: Deductibility of Wages and Benefits

​This article is excerpted from Chapter 7 of The SHRM Essential Guide to Employment Law: A Handbook for HR Professionals, Managers, Businesses, and Organizations (SHRM, 2018) by Charles H. Fleischer, Esq. 

Tax considerations drive, or at least help shape, any number of transactions in the business world. The same is true for the employer-employee relationship. With combined federal and state income tax rates at or above 40 percent, the deductibility of employer expenditures becomes a critical factor in a business's survival. At the same time, employees look to limit or defer tax on their employment-related benefits. The result is a complex web of employer opportunities and requirements.

Wages and benefits paid to employees are deductible from the employer's gross income for purposes of computing the employer's federal and state income tax, so long as the amounts are reasonable, ordinary and necessary. This means, for example, that for a corporate employer that is in the 39 percent marginal federal tax bracket and the 7 percent state tax bracket, 46 cents of each additional dollar in wages and benefits are effectively paid by federal and state governments in the form of reduced tax liabilities.

· Part 1: Deductibility of Wages and Benefits
· Part 2: Employer Liability for Sexual Harassment
· Part 3: Tax-Exempt Status for Nonprofits

As a general rule, whenever the employer takes a deduction for a wage or benefits payment, the employee who receives the payment must include it in his or her own gross income for federal and state tax purposes. The IRS keeps track of these shifting tax burdens by requiring employers to report employee payments on Form W-2 and payments to independent contractors on Form 1099.

However, the general rule has important exceptions. One exception is for items of deferred compensation—compensation that the employee cannot immediately enjoy, such as qualified retirement plan contributions. It may make little difference to an employer whether compensation to employees is in the form of wages or partly in wages and partly in the form of a qualified retirement plan contribution, since both are fully deductible if they are within the limits imposed by law. But it can make a big difference to the employee because of the time value of money.

Take, for example, an employee whose marginal tax bracket for federal and state tax purposes is 40 percent. For each additional dollar received in wages, 40 cents is paid to the government, and only 60 cents is left to save or spend. (The employee's portion of FICA and Medicare reduce even more the amount left to save or spend.) And if that 60 cents is invested, any investment income is subject to additional taxation.

In contrast, a dollar of deferred compensation is not subject to immediate tax, so the full dollar can be invested without reduction for taxes. In addition, earnings on that dollar—called inside build-up—are not subject to immediate tax either. In the end, the employee should have a greater nest egg than if he or she had received and invested after-tax wages. Of course, that nest egg is subject to income tax as it is withdrawn during retirement, but in most cases, the employee is still better off, particularly since his or her tax bracket in retirement is probably lower than when actively working.

There are other important exceptions to the general rule that whatever the employer deducts, the employee must report. For example, contributions to group health insurance, health savings accounts, and group term life insurance up to $50,000 in coverage (all discussed in Chapter 10), are generally deductible by the employer but not includable in the employee's income.

Some noncash fringe benefits may be deductible for the employer but, subject to specified limits and conditions, not includable in the employee's gross income (see IRS Publication 15-B). These include the following:

• No-additional-cost service, which is a service to an employee that the employer normally provides to its customers, as long as doing so is without substantial additional cost to the employer
• Employee discounts on goods (provided that the discount does not exceed the employer's profit margin) and on services (provided that the discount does not exceed 20 percent of the retail price)
• Working condition benefits, such as upscale office appointments and use of a company car for business purposes
• De minimis benefits, such as use of the copying machine or office supplies for personal purposes and such as eating facilities at or near the employer's premises (so long as the facility is operated on at least a break-even basis and the employer does not discriminate in favor of highly compensated employees)
• Transportation benefits, including a transit pass, parking, bicycle expenses, or cash reimbursements for those items (up to specified statutory limits)
• Cellphones provided primarily for business reasons, even though employees may use their phones for personal purposes as well.

Federal tax law allows companies to deduct all ordinary and necessary expenses of carrying on a trade or business. These include reimbursements to employees who have incurred expenses on behalf of their employers. But special rules apply to transportation and travel expenses. For example, while companies can reimburse their employees for, and then deduct, actual expenses incurred in operating an automobile for business, IRS regulations have long allowed use of standard mileage rates in lieu of providing substantiation for actual expenses.

The IRS takes a similar approach to per diem business travel expenses (meals, lodging and incidental expenses), allowing standard reimbursement/deduction rates instead of requiring substantiation of actual expenses. Employers may use one of two methods to reimburse employees, either of which satisfies the substantiation requirement. One, called the high-low method (available only for travel within the continental U.S.), allows a deduction of $282 per day for specified high-cost areas, and $189 for all other areas for 2017. See Internal Revenue Bulletin 2016-41, available on the IRS's website.

Alternatively, employers may use the federal per diem rates method, based on location-specific rates established by the federal government for cities within the continental U.S. (the CONUS rates) and outside the continental U.S. (the OCONUS rates). The U.S. Government Services Administration (GSA) establishes and publishes these rates.

The deduction for food, beverages and entertainment (but not lodging) is limited to 50 percent of the otherwise deductible amount, subject to a number of exceptions. Amounts paid to employees in excess of deductible amounts constitute income to the employees and are subject to withholding requirements and payroll taxes.

Charles H. Fleischer, Esq., is admitted to practice law in Maryland and the District of Columbia and to the Bar of the United States Supreme Court and is a member of the law firm Oppenheimer, Fleischer, and Quiggle, P.C., of Bethesda, Md. He is also a member of the Montgomery County and Maryland State Bar Associations, the Barristers (inactive), and the Montgomery County Inns of Court (emeritus).

Please visit the SHRMStore to order a copy of The SHRM Essential Guide to Employment Law: A Handbook for HR Professionals, Managers, Businesses, and Organizations by Charles H. Fleischer, Esq.