Medical Insurance and Benefits

In general, medical insurance coverage, along with any reimbursements of medical expenses, is excluded from an employee's gross income. You deduct the cost of the medical insurance premiums. If you are self-insured (you reimburse employees for medical costs out of your operating expenses under a written medical reimbursement plan), you deduct reimbursements to the employees when and to the extent made. Medical coverage, including health savings accounts (HSAs), long-term care coverage, and medical reimbursement plans, is discussed more fully in Chapter 19.

Cellular Phones

If you give cell phones or smartphones to employees, you can deduct the cost of the phone and monthly service charges without employees reporting their business usage to you.

Personal usage of employer-provided phones to employees is not taxed to the employees if there is a noncompensatory reason for providing the phones. Examples of noncompensatory reasons:

• The employer needs to contact the employee at all times for work-related emergencies.

• The employer requires that the employee be available to speak with customers or clients at times when the employee is away from the office.

• The employee needs to speak with customers or clients located in other time zones at times outside of the employee's normal workday.

Providing a phone to promote the morale or goodwill of an employee, to attract a prospective employee, or as a means of furnishing additional compensation to an employee is not providing the phone primarily for noncompensatory business purposes.

Dependent Care Assistance

Up to $5,000 may be excluded from an employee's gross income; your outlays are fully deductible. You must set up a program to provide this benefit—a plan that makes clear to your employees what they may be entitled to. You do not have to fund the plan (set money aside); instead you can pay as you go. However, as a practical matter, this benefit may not make sense for a small business since nondiscrimination rules intended to make sure that the plan does not favor owners prevents more than 25% of the amounts paid by the plan from benefiting owners (their spouses or dependents) who own more than 5% of the business.

You may allow your employees to pay for their own dependent care on a pretax basis by setting up a flexible spending arrangement (FSA) discussed later in this section.

For information about building child care facilities or offering child care referral services, see Chapter 23.

Group Term Life Insurance

You deduct the cost of providing this benefit, which is the cost of the premiums. Typical coverage runs 2 times or more of the annual salary of the employee. The cost for up to $50,000 of coverage is excludable from an employee's gross income. If coverage over $50,000 is provided, an imputed income amount for excess coverage is includible in the employee's gross income. The imputed income is calculated according to an age-based IRS table; it is not based on the actual cost of premiums. While you deduct the actual cost of providing this benefit, your employees will be pleased to learn that the income from excess coverage may be modest. Table 7.1 can be used to figure employee income from excess coverage that is reported on the employee's Form W-2. The amount shown is the cost per $1,000 of excess coverage each month.

The cost for up to $2,000 of coverage for spouses and dependents is also excludable from an employee's gross income as a de minimis fringe benefit. However, if this coverage exceeds $2,000, then all of the coverage (not just the amount above $2,000) is taxable to the employee.

If a group insurance plan is considered to be discriminatory, key employees (owners and top executives) will have income from the coverage and will not be able to exclude the cost for the first $50,000 of coverage. In this instance, income to them is the greater of the actual cost of the coverage, or the imputed amount calculated according to the age-based IRS tables. Special insurance coverage arranged on an individual basis (for example, split-dollar life insurance) is discussed later in this chapter.

Educational Expenses

If the courses are job related, your payments are deductible as noncompensatory business expenses. If the courses are not job related, your expenses are deductible as wages. If you lay off workers and pay for their retraining, you may also deduct your payments.

There is a special exclusion of up to $5,250 for employer-financed education assistance, including graduate-level courses, under a qualifying plan.

Amounts you pay for an employee under the plan can be excluded from the employee's income even if the courses are not job related. In that case, your payments under the plan would be deductible as noncompensatory business expenses.

As a practical matter, it is generally not advisable for owners of small businesses to set up educational assistance plans for the same reason that dependent care assistance programs may not make sense—no more than 5% of benefits can go to owner-employees or their spouses or dependents.

Adoption Assistance

You may deduct the cost of adoption assistance you provide to your employees. If you set up a special assistance program (a separate written plan to provide adoption assistance), your employees can exclude up to $13,460 per child in 2016. However, in 2016 the exclusion is phased out for those with adjusted gross income (AGI) between $201,920 and $241,920 (regardless of your filing status as married or single).

As in the case of educational assistance plans, adoption assistance plans do not make sense for small employers, since no more than 5% of benefits can go to owner-employees.

Retirement Planning Advice

If you maintain a qualified retirement plan, you can pay for expert advice for your employees and their spouses with respect to retirement planning, and they are not taxed on this benefit. There is no dollar limit to the exclusion. However, it does not apply to tax preparation, accounting, legal, or brokerage services. If you pay for these services on behalf of your employees, they are taxed on this amount, although you can deduct your payments.

Health Savings Accounts

If you maintain a high-deductible health insurance plan and contribute to a Health Savings Account (HSA) for an employee, you can deduct your contributions. Contribution limits and other rules for Health Savings Accounts are discussed in Chapter 19. Contributions are not taxed to employees and are exempt from payroll taxes. You must complete contributions by April 18, 2017, in order to deduct them on your 2016 return (even if you obtain a filing extension).

Note: If you are a small business or a self-employed individual, you can contribute to an Archer Medical Savings Account (MSA), assuming the account was set up prior to 2008.

HSAs and MSAs are discussed more fully in Chapter 19.

Health Reimbursement Accounts (HRAs)

These are plans under which an employee can draw up to a dollar limit fixed by the employer to cover out-of-pocket medical expenses. Until now, HRAs have been used to supplement employer-provided health coverage. These plans are discussed more fully in Chapter 19.

Cafeteria Plans and Flexible Spending Accounts

If you make contributions to cafeteria plans, you can claim a deduction as an employee benefit expense. Cafeteria plans are designed to offer employees choices among benefits on a nondiscriminatory basis. Simple cafeteria plans for small employers are explained later in this chapter.

Flexible spending accounts (FSAs) are also nondiscriminatory plans but are funded primarily with employee contributions. Flexible spending accounts are intended to cover medical costs or dependent care costs on a pretax basis. Employees agree to salary reductions (within limits set by law) that are then contributed to the FSA to be used for medical costs or dependent care costs. The dollar limit in 2016 on elective deferrals is $2,550 to medical FSAs and $5,000 for dependent care FSAs.

Generally, employee elective deferrals to FSAs are done on a use-it-or-lose-it basis. If qualified expenses for the year do not equal these amounts, contributions are lost. However, medical FSAs can add either of these features (but not both):

• Carryover up to $500. The plan can allow unused amounts to be carried over to the following year. The carryforward is not cumulative, so that no more than $500 can ever be added to the basic elective deferral for the following year.

• Grace period. The plan can allow unused amounts to be used within a period of up to 2½ months after the close of the year (March 15th).

From your perspective, however, you may be on the hook for payments if the plan pays out more than the employee has paid in and the employee then terminates employment. The reason: The plan must pay out benefits equal to the employees' annual commitment for salary reduction contributions, even if they have not been fully paid.

Supplemental Unemployment Benefits

If you make contributions to a welfare benefit fund to provide supplemental unemployment benefits for your employees, you may deduct your contributions as ordinary and necessary business expenses. The deduction is claimed as an employee benefit expense, not as a compensation cost. Your deduction cannot exceed the fund's qualified cost for the year. Qualified cost is the amount you could have claimed had you provided the benefits directly and been on the cash basis, plus the amount estimated to be actually necessary to build the fund to cover claims incurred but not yet paid and administrative costs for such claims.

Meals and Lodging

In general, the costs of providing meals and lodging to your employees are deductible as an expense of operating your business. The costs may or may not be taxable to your employees. The tax treatment of this benefit to your employees affects the amount and how you claim a deduction. Generally, you may deduct only 50% of the cost of providing meals.

The 50% limit on deducting meals does not apply if your employees must include the benefit in income. In this case, you may deduct 100% of the cost as compensation.

The 50% limit on deducting meals does not apply if you operate a restaurant or catering business and provide meals to your employees at your restaurant or work site. However, in this case, the full cost of the meals is not deductible as compensation; instead, it is treated as part of the cost of goods sold.

The 50% limit on meals does not apply if you provide the meals as part of the expense of providing recreational or social activities. For example, the cost of a company picnic is fully deductible.

You may deduct the full amount of meal costs if your employees are able to exclude this amount from their gross income. They do this if the meals are furnished on your premises and for your convenience, or if the meals qualify as a de minimis fringe benefit.

Special rules apply for valuing the meals provided at an employer-operated eating facility. An employer-operated eating facility is a lunchroom or other facility that you own or lease and operate directly or by a contract to provide meals on or near your business premises during or immediately before or after your employees’ workday. Meals provided at an eating facility on or near your business premises are treated as a de minimis fringe benefit. As such, they are excluded from your employee's income and you can claim a full deduction (you do not have to apply the 50% limit).

If you provide your employees with lodging on your premises (for example, if you run a motel, nursing home, or rental property and the employee must live on the premises in order to manage it), you may deduct your full expenses according to the particular expense involved. For example, you deduct the cost of heating and lighting as part of your utilities, the cost of bedding as part of your linen expenses, and the use of the room as a depreciation item.

However, if you are a self-employed individual, you cannot make your living costs tax deductible. You may not exclude them even if you live at your business (e.g., you own a motel and live in it) since you are not an employee of your business.

Housing Relocation Costs

While this may be rare, a small business may provide relocation assistance to an employee by helping with the sale of the employee's home. The business may deduct as “compensation” the payment of expenses related to the home where the employee retains the right to negotiate for a final sale price.

Travel and Entertainment Costs

If you pay for travel and entertainment costs, you may deduct your outlays, subject to certain limits. These expenses are explained in Chapter 6.

Employee Use of a Company Car

If you allow an employee to use a company car for personal purposes, you must value this personal use and include it in the employee's gross income. It is a noncash fringe benefit. There are several valuation methods for calculating personal use of a company car. The method to use depends on your particular circumstances.

One method is based on the actual fair market value (FMV) of the personal use. This is determined by looking at the cost of leasing a comparable car at a comparable price for a comparable period of time. The cost of the vehicle can be its FMV if the car was purchased in an arm's-length transaction. Under a safe harbor rule, you can use the manufacturer's invoice price (including the price for all options), plus 4%. Under another safe harbor rule, you can use the manufacturer's suggested retail price, minus 8%. Then find out what it would cost to lease a car of this value.

Another method is based on the car's annual lease value (ALV). The ALV is set by the IRS and depends on the FMV of the car on the date the car is first used for personal purposes (see Table 7.2).

For cars over $59,999, calculate the ALV as follows: Multiply the fair market value of the car by 25% and add $500. The ALV figures apply for a 4-year period starting with the year of the ALV election. Thereafter, the ALV for each subsequent 4-year period is based on the car's then fair market value.

If the car is used continuously for personal purposes for at least 30 days but less than the entire year, you must prorate the value of personal use.

The ALV method already takes into account maintenance and insurance costs. Fuel provided by an employer is not included in the ALV. Fuel provided in kind can be valued at FMV or 5.5¢ per mile for purposes of including it in the employee's gross income. If fuel is paid by a company credit card, the actual charges are used to compute personal use included in the employee's gross income.

An employer may choose to treat all use by an employee of a company-owned car as personal use and include an appropriate amount in the employee's gross income. In this case, it is up to the employee to maintain records substantiating business use and then deduct such business use on his or her individual income tax return. If personal use of a company car is de minimis, then nothing need be included in the employee's gross income. As a practical matter, when the employee is an owner, the decision on how to value personal use of a company car is a mutual decision. Both the employer and employee in this case agree on which method is preferable. Keep in mind that when valuing personal use for an owner, only the fair market value or ALV methods can be used.

Another valuation method for personal use of a company car is the cents-per-mile special rule. This rule can be used only if a car is valued in 2016 at no more than $15,900 ($17,700 for a truck or van) and the car is regularly used in the business (at least 50% of total annual mileage is for the business, or the car is used each workday to drive at least 3 employees to and from work in a carpool) or for a car driven by employees at least 10,000 miles during a calendar year. And the employee cannot be a control employee (see below). If the car is owned or leased for less than a full year, the 10,000 miles are prorated accordingly. The value of personal use is based on the standard mileage rate. The standard mileage rate for 2016 is 54¢ per mile.

There is another method for valuing personal use of company vehicles called the fleet valuation method. This applies to companies with a fleet of 20 or more vehicles, something that small businesses do not have; this method is not explained further in this book.

If you want to use the ALV method or the cents-per-mile method, you must elect to do so. This election must be made no later than the first pay period in which the company car is used for personal purposes. You need not inform the IRS of your election.

Another method for figuring income to the employee for using a company car is the fixed and variable rate (FAVR) allowance. This is a reimbursement amount that includes a combination of payments covering fixed and variable costs, such as the cents-per-mile rate for variable operating costs (e.g., oil and gasoline) and a flat amount for fixed costs (e.g., depreciation or lease payments). The FAVR allowance is based on a standard automobile cost that cannot exceed $28,000 in 2016 ($31,000 for trucks and vans).

Commuting Vehicles

If you allow your employees to use company cars to commute to and from work, a special valuation rule is used to determine the amount includable in the employee's gross income. The car must be owned or leased by the employer for use in the business, and the employer must have genuine noncompensatory business reasons for requiring an employee to commute in the vehicle. Also, the employer must have a written policy preventing use of the vehicle for personal purposes other than commuting (or de minimis personal use). The employee cannot be a control employee (an employee who is a board-appointed, shareholder-appointed, confirmed, or elected officer with compensation of at least $50,000, a director, a 1% or greater owner, or someone who receives compensation of $100,000 or more). If the special commuting vehicle rule is met, then the value of commuting is $1.50 each way ($3.00 round trip), regardless of the length of the commute. The same flat rate applies to each employee even if more than one employee commutes in the vehicle. While the commuting vehicle rule is optional at the employer's election, it must be used for valuing all commuting if it is used for valuing any commuting.

The deduction for car expenses—depreciation, insurance, gas, oil, and repairs—is explained in Chapter 9. This chapter covers only business use of a company car.

Country Club Dues

If you pay the cost of membership at a golf or other country club, the dues are not deductible. However, an employee who uses the club for business can exclude the benefit from income (it is viewed as a working condition fringe benefit, explained, later even though country club dues are otherwise not deductible). However, you can convert this nondeductible cost of the business into a deductible expense by electing to treat the benefit as additional compensation to the employee—deducting the cost as compensation and not as an entertainment cost. This option is discussed more fully in Chapter 8.

Split-Dollar Life Insurance

Under a split-dollar life insurance plan, the cost of coverage is shared between the business and the insured. Here is how the plan usually works.

A cash value life insurance policy is used for a split-dollar arrangement, with the business paying some or all of the premiums. At the death of the employee, the business recoups its outlay, and the balance of the proceeds is payable to the insured's beneficiary (typically his or her spouse or child). Under final regulations, how the employee is taxed on this benefit depends on who owns the policy:

• If the employee owns the policy, premiums paid by the business are treated as loans, with imputed interest taxed to the employee.

• If the business owns the policy, the employee is taxed on the value of the life insurance protection (which is the 1-year term cost of this protection).

In view of income tax being imposed on split-dollar life insurance arrangements, they are no longer favored as wealth builders for business owners.

WORK OPPORTUNITY CREDIT

To encourage employers to hire certain individuals from specially targeted groups, there is a tax credit called the work opportunity credit. A top credit of up to $9,600 applies to certain veterans, but smaller credits are allowed for hiring other individuals.

The credit applies for hiring an employee from one of the following targeted groups:

1. Member of a family receiving Temporary Assistance for Needy Families (TANF)

2. Qualified veteran (there are 5 subcategories)

3. Qualified ex-felon

4. Designated community resident

5. Vocational rehabilitation referral

6. Summer youth employee

7. Recipient of SNAP benefits (food stamps)

8. SSI recipient

9. Long-term family assistance recipient

10. Long-term unemployed (someone who has been unemployed for at least 27 consecutive weeks and received government unemployment benefits)

The amount of the credit varies with the targeted group category and, in some cases, the term of employment. The basic credit amount is 40% of first year wages up to $6,000, for a top credit of $2,400. This basic amount applies for those who work at least 400 hours. For those who are retained on the job for at least 120 hours but not more than 400 hours, the credit percentage drops to 25%, for a top credit of $1,500. However, the credit for summer youth is limited to 40% of wages up to $3,000, for a top credit of $1,200. And the credit for veterans with service-connected disability who are employed for at least 6 months is 40% of wages up to $24,000, for a top credit of $9,600.

There is no limit on the number of employees who can be hired to generate the work opportunity credit. What's more, some states have their own work opportunity programs, so check with your state revenue department.

If you employ an eligible worker, be sure to obtain the necessary certification from your state employment security agency. This is done by having the employee sign IRS Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, on the first day of work and submitting it to your state workforce agency within 28 days of the new employee's starting work, along with the Department of Labor's Employment and Training Administration (ETA) Form 9061, Individual Characteristics Form or Form 9062, Conditional Certification. Without having submitted this form, you cannot claim the credit, but if you make a timely submission, you claim the credit even if the state agency fails to respond to you. It is highly advisable to get a new employee to sign the form and timely submit it to the state workforce agency if the agency is willing to accept it. If the work opportunity tax credit is not extended, all that is lost is your effort in the submission (i.e., no additional cost to you); if the credit is extended, then you have nailed it down and need take no further action.

Employer Credit for FICA on Tips

Owners of restaurants and beverage establishments can claim a credit for the employer portion of FICA paid on tips related to the furnishing of food and beverages on or off the premises. This is 7.65% of tips in excess of those treated as wages for purposes of satisfying the minimum wage provisions of the Fair Labor Standards Act (FLSA).

Empowerment Zone Employment Credit

The Departments of Housing and Urban Development and Agriculture initially named 6 cities and 3 rural economically distressed areas across the country as empowerment zones (Round I zones) and in 1998 named 22 more (Round II). In addition, the District of Columbia is an enterprise zone—another type of economically distressed area—and employers in the zone are eligible for the empowerment zone employment credit. Eight additional employment zones have been designated (Round III). If you do business in one of these economically depressed zones and hire part-time or full-time employees who perform substantially all of their employment services within the zone, you may claim a credit based on their wages. The credit is 20% of the first $15,000 of qualified wages. The top credit is $3,000 per employee per year. There is no limit on the number of employees for which you may claim the credit. Wages for purposes of calculating the credit include not only salary and wages but also training and educational benefits. To determine whether a particular area has received designation, go to http://egis.hud.gov/ezrclocator/.

Indian Employment Credit

You can claim a credit if you employ part-time or full-time workers who receive more than 50% of their wages from services performed on an Indian reservation. The employee must be an enrolled member of an Indian tribe or a spouse of an enrolled member. The employee must also live on or near the reservation on which the services are performed. The credit is 20% of the first $20,000 of excess wages and the cost of health insurance. Excess wages and health insurance costs are such costs over amounts paid or incurred during 1993. However, wages paid to any employee earning more than $30,000 are not taken into account; such employee is not a qualified employee.

Employer Wage Credit for Activated Reservists

If you continue some or all of the wages of employees called to active duty (called a differential wage payment), you can take a tax credit of 20% of the differential that does not exceed $20,000 (a top credit of $4,000).

This credit applies only to small employers (on average fewer than 50 employees) that have a written plan to provide the wage differential. No deduction for compensation can be claimed if the compensation is a differential wage payment used to determine this credit.

General Business Credit

Some employment tax credits are part of the general business credit. As such, they not only reduce your deduction for wages but are also subject to special limitations. The general business credit is the sum of employment tax credits and certain other business-related credits. The general business credit cannot exceed your net tax liability (tax liability reduced by certain personal and other credits), reduced by the greater of:

• Tentative minimum tax (the alternative minimum tax before the foreign tax credit), or

• 25% of regular tax liability (without regard to personal credits) over $25,000.

The amount of the general business credit in excess of this limit can be carried back for one year. Any additional excess amount can then be carried forward for up to 20 years. You cannot elect to forgo the carryback. (For credits arising in tax years before 1998, the carryback period was 3 years, and the carryforward period was 15 years. For credits arising in 2010 of small businesses with average annual gross receipts not exceeding $50 million, there was a 5-year carryback but the same 20-year carryforward.)

Earned Income Credit

If you employ an individual whose income is below threshold amounts, the employee may be eligible to claim an earned income credit. This is a special type of credit because it can exceed tax liability. It is called a refundable credit, since it can be paid to a worker even though it more than offsets tax liability.

Note: Self-employed individuals who had a bad year in business may be eligible for the earned income credit. Find more details about this personal refundable tax credit in IRS Publication 596, Earned Income Credit (EIC).

Dependent Care Credit

Whether you are an employee or a business owner, if you hire someone to look after your children under age 13 or a disabled spouse or child of any age so that you can go to work, you may claim a tax credit. This is a personal tax credit, not a business tax credit. You claim the credit on your individual tax return.

The credit is a sliding percentage based on your adjusted gross income (AGI). The top percentage is 35%; it scales back to 20% for AGI over $43,000. This is the AGI on a joint return if you are married and do not live apart from your spouse for the entire year.

The percentage is applied to certain employment-related expenses up to $3,000 per year for one dependent, or $6,000 per year if you have 2 or more qualifying dependents. Employment-related expenses include household expenses to care for your dependent—housekeeper, babysitter, or nanny—and out-of-the-house expenses for the care of dependents, such as day-care centers, preschools, and day camps. Not treated as qualifying expenses are the costs of food; travel to and from day care, preschool, or day camp; education; and clothing. Also, the cost of sleep-away camp does not qualify as an eligible expense.

If you are eligible for a credit, be sure to get the tax identification number of anyone who works for you and the day-care center or other organization to which you pay qualified expenses. The tax identification number of an individual is his or her Social Security number. You must include this information if you want to claim the credit.

If you hire someone to work in your home, be sure to pay the nanny tax. This is the employment taxes (Social Security, Medicare, and FUTA taxes) on compensation you pay to your housekeeper, babysitter, or other in-home worker. You must pay Social Security and Medicare taxes if annual payments to a household worker in 2016 exceed $2,000. If you paid cash wages of $1,000 or more in any calendar quarter to a household employee during the current tax year or the previous year, you also must pay federal unemployment tax (FUTA) on the first $7,000 of wages. You do not pay these taxes separately but instead can report them on Schedule H and include them on your Form 1040. You should increase your withholding or estimated tax to cover your liability for them to avoid estimated tax penalties. You cannot deduct employment taxes on household workers as a business expense. However, the tax itself is treated as a qualifying expense for the dependent care credit.