Employer Guide: What Employee Compensation Is Taxable?

Employee Pay and Benefits Taxed
•••

Enis Aksoy / Getty Images

When it comes to figuring taxable income for your employees, it can be difficult to sort out what's taxable to the employees and what is not. It seems like every kind of income is taxable, but that's not necessarily true.

This article looks at the types of payments a business makes to employees, which of these payments are taxable, and any exceptions.

"Taxable" in this article relates to income for federal income tax purposes as reported on an employee's annual W-2 form. It doesn't include wages and benefits that must be included for FICA tax (Social Security/Medicare) purposes. Some benefits that are taxable for W-2 purposes may differ from benefits taxable for FICA purposes.

Just to make things more complicated, you must withhold federal and state income taxes from pay and benefits that are taxable to employees. In addition, you must withhold FICA taxes (Social Security and Medicare) from some, but not all of these benefits,

Taxable Pay and Benefits

All payments your business makes to employees for work are taxable, including

Here are some more details:

Employee gross income is taxable to the employee, including overtime pay for non-exempt employees and certain lower-income exempt employees. 

All tip income is included with all other income in the relevant boxes on Form W-2. Notice that allocated tips (those determined by a formula for all tipped employees) are to be shown in Box 8, but not in other income items. 

Employee commissions are included in taxable income. If an employee received advance commissions for services to be performed in the future, those commissions are, in most cases, taxable when received by the employee. 

If an employee is using a company car for business purposes, you must separate the employee's personal use from business use of the car. The employee's personal mileage is taxable as a benefit.

Stock options may be taxable to employees when the option is received, or when the option is exercised, or when the stock is disposed of. 

Employee bonuses and awards for outstanding work are generally taxable to the employee. This includes trips given as prizes for meeting sales goals.

Gifts to employees are also taxable to the employees, including gift cards and items given at holiday times, but small gifts may not be taxable to employees if the gifts follow de minimis rules (explained below).

Moving expenses are considered an employee benefit and these payments are taxable to the employee, from 2018 through 2025. Even if your business has an accountable plan for distributing and keeping track of these moving costs, they are still taxable to the employee.

De minimis (Minimal) Benefits

De minimis benefits are small gifts given to employees that are given infrequently (not regularly) and have little value. These gifts are not taxable to the employees. An example of a de minimis benefit might be a fruit basket you give to an employee for a holiday. The key with de minimis benefits is that they are small and occasional and it would be impractical and unreasonable for your accounting department to deal with them. 

You may have heard that if you give a gift card under $25 to an employee it's not taxable. That's not true. The IRS says that cash and cash equivalents (gift cards or gift certificates or the use of a charge card, for example) no matter how small, are never considered de minimis, and these payments are taxable to the employee.

You may also give employees a meal occasionally without taxing them For example, you might provide coffee and donuts for a meeting, or have a company picnic. These may be considered de minimis if they are occasional and have little value. If you have a company cafeteria, that expense might also be considered de minimis for employee tax purposes, under certain circumstances. 

How to Value Employee Benefits

For tax purposes, you must include a specific amount for the value of benefits. The general valuation rule uses the fair market value (FMV) of the benefit. The taxable amount to the employee is the difference between the fair market value and the amount the employee paid for it.

For example, if the employee paid you $100 for something, and the FMV is $200, you gave the employee a $100 benefit, so that's taxable.

You can also use the Cents-Per-Mile Rule to determine employee mileage with the standard mileage rate, and other valuation rules are available for specific circumstances.

Non-Taxable Benefits and Other Payments

Working condition benefits are property or services that would be allowable as a business expense or depreciation expense to the employee if they paid for them. Two examples are a company car for business use or a subscription to a professional publication. If you give cash to an employee for any of these expenses, the employee must give you verification that the cash was spent for that item, and they must return unused cash.

Cell Phones. If you give an employee a cell phone for primarily business use, its value isn't taxable to the employee. The employee's personal use of the phone is considered de minimis (see discussion above). 

Health Insurance. if an employer pays the cost of an accident or health insurance plan for employees, these payments are not wages and are not subject to federal income tax withholding. But the cost of these benefits must be included in the wages of S corporation employees who own more than 2% of the company. 

Worker's compensation benefits are not taxable to employees if they are paid as part of a state's worker's compensation program. Other payments to employees who are receiving worker's compensation benefits (such as a pension) are taxable to the employee. 

Commuter and transportation benefits from businesses to their employees are typically excluded from being taxed. There are exceptions and limits, so read more about how these commuting and transportation benefits work, including bicycling, parking, and mass transit benefits. 

An exception: Starting in 2018, if you reimburse employees for bicycle commuting expenses, these reimbursements must be included in the employee's gross income for tax purposes. 

Meals provided to employees may not be taxable if they are small and infrequently provided under de minimis rules (above). The IRS has complicated rules about what employer-provided meals are and are not taxable. 

The cost of up to $50,000 of life insurance provided to employees isn't included in their income. But life insurance costs paid by your company of over $50,000 are taxable to employees. This cost is included in Box 1 and in Box 12 of the W-2 as one of the options. 

Educational assistance benefits under $5,250 paid to employees in a calendar year are not taxable to the employee if there are provided as part of a qualified educational assistance program. For more information on educational assistance programs, see IRS Publication 971

Other types of employee fringe benefits may be exempt from income taxes if they meet certain conditions and limits. Table 2-1 from IRS publication 15-B (page 6) gives more information about these benefits.

Who Is An Employee for These Tax Purposes? 

This information is to help business owners in understanding taxable pay and benefits to employees. It doesn't include payments to independent contractors except for direct payment for services. 

Certain Subchapter S corporation shareholders who receive pay as employees and who own more than 2% of the corporation's stock are not considered as employees for purposes of taxing pay and benefits. You must treat this person as a partner in a partnership for fringe benefit purposes. Subchapter S 2% ownership employees aren't exempt from tax on meals, accident and health benefits, lodging benefits, adoption assistance, and achievement awards.

The information in this article is provided as a general overview. It's not meant to give you all the details of specific situations. IRS regulations for taxable employee pay and benefits are complicated, and there are many limitations and exclusions to non-taxable benefits. Get help from your tax professional before you calculate employee withholding and prepare annual W-2 forms.

For More Information

You can find more detailed information on the tax status of various employee benefits in IRS Publication 15-B, and IRS Publication 525 has more details on employee compensation and taxes. 

Article Sources

  1. IRS. "Publication 525 Taxable and Nontaxable Income."   Employee Compensation. Page 3. Accessed Feb. 7, 2020. 

  2. IRS. "Publication 525 Taxable and Nontaxable Income." Miscellaneous Compensation. Page 3. Accessed Feb. 7, 2020. 

  3. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Center-Per-Mile Rule. Page 25. Accessed Feb. 19, 2020.

  4. IRS. “Publication 15-B Employer’s Tax Guide to Fringe Benefits.” Stock Options. Page 12. Accessed Feb. 7, 2020. 

  5. IRS. "Publication 525 Taxable and Nontaxable Income."   Bonuses and awards. Page 3. Accessed Feb. 7, 2020. 

  6. IRS. “Publication 15-B Employer’s Tax Guide to Fringe Benefits.” De Minimis "(Minimal) Benefits. Page 9. Accessed Feb. 7, 2020. 

  7. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Reminders Moving expense reimbursements. Page 2. Accessed Feb. 19, 2020.

  8. IRS. “Publication 15-B Employer’s Tax Guide to Fringe Benefits.” De Minimis Meals. Page 17. Accessed Feb. 7, 2020. 

  9. IRS. "Employee Benefits." Fringe Benefit Valuation Rules. Page 24ff. Accessed Feb. 7, 2020.

  10. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Working Condition Benefits. Page 22. Accessed Feb. 19, 2020.

  11. IRS. “Publication 15-B Employer’s Tax Guide to Fringe Benefits.” Employer-Provided Cell Phones. Page 12ff. Accessed Feb. 7, 2020. 

  12. IRS. "Employee Benefits." Health Plans. Accessed Feb. 7, 2020.

  13. IRS. "Publication 525 Taxable and Nontaxable Income."  Worker's Compensation. Page 19. Feb. 7, 2020. 

  14. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Transportation (Commuting) Benefits. Page 20. Accessed Feb. 19, 2020.

  15. IRS. "Publication 525 Taxable and Nontaxable Income." Reminders. Page 2. Accessed Feb. 6, 2020.

  16. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Meals. Page 17. Accessed Feb. 19, 2020.

  17. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Group-Term Life Insurance Coverage. Page 13. Accessed Feb. 19, 2020.

  18. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Educational Assistance. Page 9. Accessed Feb. 19, 2020.

  19. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits.". Table 2-1. Page 6. Accessed Feb. 19, 2020.IRS.

  20. IRS. "Publication 15-B Employer's Tax Guide to Fringe Benefits." Exception for S corporation shareholders. Page 4. Accessed Feb. 19, 2020.