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 everything you need to know about deducting employee benefits on your business tax return.
Requirements for Deducting Employee Benefits
The general principles for deducting employee payments are:
- 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, and you must be able to prove that 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 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 an arm’s length transaction to buy or lease the benefit.
For 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.
On the other side of the issue, you need to know which benefits are taxable to employees as compensation.
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.
Other Employee Payments You Can Deduct
Your business can generally deduct the costs of fringe benefits you give to employees. But with the passing of the Tax Cuts and Jobs Act, which went into effect in tax year 2018, you can’t deduct entertainment expenses for your business or employees.
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 still deduct bicycle commuting reimbursements, but you must include the amounts in employee pay.
Awards to Employees
You can deduct the cost of awards to employees, including achievement awards and safety achievement awards, but 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 a qualified educational assistance program. Highly paid employees, owners, or their spouses or dependents are ineligible for this program, but you can include yourself if you are a sole proprietor or partner in a partnership.
You can deduct the costs of employee benefits programs, including:
- Accident and health plans
- Adoption assistance
- Cafeteria plans
- Dependent care assistance
- Education assistance
- Life insurance coverage
- Welfare benefit funds
It’s important to know that you can’t deduct the cost of life insurance for someone with a financial interest in your business if you are directly or indirectly the beneficiary. But when it comes to health plans, premiums 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 for employees are deductible, but the plan must be qualified by the IRS. It’s best to get an employee benefits specialist to help you set up a plan.
The Bottom Line
The IRS regulations on deducting employee pay and benefits are complicated. Each type of payment has restrictions and qualifications, and every business situation is unique. See IRS Publication 535 Business Expenses for more details. Also, 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.