Deducting Employee Benefits on Your Business Tax Return
There’s a lot that goes into taking these deductions
The costs of benefits you give to employees—such as gifts and health plans—are deductible as expenses on your business tax return. That sounds easy, but it's not because there are many details involved in taking these deductions. Here’s what you need to know about deducting employee benefits on your business tax return.
Requirements for Deducting Employee Benefits
Here are some general principles for deducting employee payments or benefits:
- The payments must be ordinary and necessary business expenses.
- Your business must pay or be liable for these costs.
In addition, the payment amount must be reasonable, based on the circumstances and an amount a similar business would pay for the services. They also must be connected to services (work) the employee actually performed services for these payments.
In the restrictions on many benefits, you may see that certain employees or owners cannot participate, or that your deduction may be limited for those individuals. For example, you can’t favor highly-paid employees by giving them some benefits, while other benefits have exceptions for other categories of employees. This occurs, for instance, when there are restrictions on accident and health benefits for S corporation shareholders or employees who own 2% or more of the company’s stock.
How to Value Employee Benefits
For most benefits, you must use a fair market value (FMV) rule to determine the cost you can deduct. FMV is the amount an employee would have to pay someone else in a transaction between two independent (non-related) parties to buy or lease the benefit.
For example, when it comes to reimbursements to employees for business driving, you must use the standard mileage rate, which changes each year, and have in place a commuting rule for any vehicles you provide to employees for commuting.
Deducting Employee Pay
You can deduct payments to employees, including salary, wages, bonuses, tips, and commissions, as well as holiday pay, vacation, sick leave, and other similar paid time off. Here’s how you would deduct some of those payments:
- Bonuses: You can deduct the cost of paying bonuses to employees if the bonus is for services rendered, and not a gift.
- Sick pay: You can deduct amounts paid to employees for sickness and injury, but only amounts not covered by insurance or other means.
- Vacation pay: You can deduct vacation pay only for the tax year in which the employee receives it.
- Advances and loans: You can deduct advances on employee wages even if you don’t expect the advance to be repaid. If the employee doesn’t perform any services or doesn’t repay you, consider the amount as a loan and include it in the employee’s taxable pay.
Deducting Fringe Benefits
You can deduct the costs of employee benefits programs, including:
- Accident and health plans
- Adoption assistance
- Cafeteria plans
- Dependent care assistance
- Life insurance coverage
- Welfare benefit funds
Premiums your company pays for group hospitalization and medical insurance for employees are deductible. You can also deduct your costs for workers’ compensation insurance premiums and state unemployment insurance fund tax (if the unemployment insurance is considered a tax by your state).
Costs for setting up and administering a group health plan or retirement plan for employees are deductible, but the plan must be qualified by the IRS for tax deduction purposes. It’s best to get an employee benefits specialist to help you set up a plan.
Other Employee Payments You Can Deduct
Businesses need well-informed employees who are up to date with the latest trends and technology in their fields. The cost of professional journals, trade publications, and business magazines and books is well within the limits of "reasonable and necessary" business expenses, but be sure to include only business or professional publications.
Tools and Uniforms
You can take a business tax deduction for tools and uniforms that you buy for employees to use in their work. Some employers deduct the cost of these items from employee paychecks. Federal law allows this deduction, as long as it doesn't reduce the employee's wage below the federal minimum wage amount. Costs to clean your employees' uniforms are also deductible business expenses.
Some states have stricter requirements for deducting these costs from employee paychecks. Check with your state's employment division to make sure you know the current law.
Because of the 2017 Tax Cuts and Jobs Act, as of 2018, businesses can no longer deduct the cost of entertainment from business tax returns. But you can still deduct employee meal costs in certain situations, most at 50%.
- Meals for employees while traveling or having dinner with clients on company business are still deductible to your business.
- Meals for employees you provide at your location, like your cafeteria or break room, are deductible at 50% (not 100%).
- Meals for employees as part of recreational or social activities (like a holiday party) are deductible at 100%.
Your business can give employees discounts on products or services you offer to customers without including these discounts in taxable employee pay. The main qualification is that the discount must be in the area where the employee performs "substantial service" and they must be items customers could buy. For example, if an employee works in your sign company, you can give them a discount on signs, but not on paint used on signs.
There are limits on the amount of the discounts and restrictions on types of services. For example, if a retailer implements a fringe benefit program that provides discounts on merchandise to all employees, and a second program that offers additional discounts which favor highly-compensated employees, the additional discount is not considered a qualified employee discount.
Your business can no longer deduct reimbursements for certain commuting benefits, including van pools, commuter highway vehicles, transit passes, or parking, unless these expenses are for transportation “necessary for ensuring the safety of your employee.”
You can, however, still deduct bicycle commuting reimbursements, but you must include the amounts in employee pay.
Achievement Awards to Employees
You can deduct the cost of length of service or safety achievement awards you give to employees, if they are tangible personal property (like a trophy or certificate). Each type of award has restrictions on who can receive it and the amount of the award.
Gifts of cash, cash equivalents, gift cards, gift coupons, or gift certificates, tickets to sporting events, vacations, meals, lodging, stocks, bonds, or securities aren’t deductible. You can deduct awards of property to employees if they are part of a catalog or assortment of possible items.
Education Assistance Expenses
If you pay for employee education expenses, you can deduct some of these costs if you have an IRS-qualified educational assistance program. Highly-compensated employees, owners, or their spouses or dependents aren't eligible for this program, but you can include yourself if you are a sole proprietor or partner in a partnership.
Student Loan Payments to Employee
Employers can now pay student loans for employees, which are tax-deductible to the employer and not taxable to the employee. The 2020 CARES Act expanded the definition of educational assistance to include certain employer payments of employees' student loans. The payments must be paid after March 27, 2020, and before January 1, 2026, unless extended. See Chapter 11 of IRS Publication 970 for details.
- IRS Publication 535 Business Expenses has details on deducting employee benefit expenses.
- IRS Publication 15-B Employer's Tax Guide to Fringe Benefits has details about which benefits are taxable to employees and on requirements for IRS-qualified plans.
Get Help From a Tax Professional
The IRS regulations on deducting employee pay and benefits are complicated. Each type of benefit has restrictions and qualifications, and every business situation is unique. To be safe, ensure accuracy, and save you from costly errors when filing your business tax return, consider getting help from a tax professional before you attempt to take deductions.