July 1, 2008

Watch Out for Fringe Benefit Misclassification      

by: Ilona Borish, Partner

 

 

 

 

 

 

 

 

For many businesses, fringe benefits are an important tool for rewarding executives and other valued workers. And many benefits receive tax-favored treatment, which helps both employers and employees.

But the IRS is concerned that many companies are misclassifying fringe benefits that should be treated as compensation and be subject to income and employment taxes. To curb abuses in this area, the IRS issued the Executive Compensation — Fringe Benefits Audit Techniques Guide. Although the guide was intended for IRS examiners, it provides businesses with a handy roadmap they can use to determine whether their fringe benefits satisfy IRS requirements.

Benefits presumed to be taxable

Fringe benefits can raise a number of issues for any business because the expense may — or may not — be deducted by the employer or excluded from the employee’s gross income.

That’s why it’s helpful to know what the IRS requires. The guide instructs examiners to analyze fringe benefits using this three-step approach:

1.                  Identify the fringe benefit and start with the assumption that its value will be taxable as compensation to the worker.

2.                  Check to see if there are any statutory provisions that exclude the benefit from the employee’s income.

3.                  Value any nonexcludible portion of the benefit for inclusion in the worker’s gross income.

Fringe benefits are generally valued at the amount the employee would have to pay for the benefit in an arm’s-length transaction.

Common fringe benefits

The guide discusses common fringe benefits such as:

Club memberships. Most club dues aren’t deductible, including those for business, social, athletic, sporting, airline and hotel clubs. But an employer may deduct the cost if it treats club dues as compensation includible in an employee’s gross income and wages.

If the employer doesn’t treat club dues as compensation, employees may exclude the dues from their income as a working-condition fringe benefit, provided the dues otherwise qualify as a deductible business expense.

The guide alerts examiners that some corporations attempt to deduct club dues by disguising them as compensation paid to departing employees as part of their severance packages. The value of such club memberships should be included in taxable wages, so the guide advises examiners to scrutinize employment contracts and severance agreements.

Athletic skyboxes and entertainment suites. For luxury skyboxes leased for more than one event, a business may deduct up to the face value of a nonluxury box seat for each luxury seat in the skybox. The remaining cost of attendance is deductible to the extent it satisfies the requirements for deducting entertainment expenses. If the skybox is used personally by top executives, the value of the benefit may be taxable income. Luxury boxes rented by related parties are treated as a single lease in determining whether the boxes are leased for more than one event.

The audit guide also discusses a variety of other fringe benefits such as corporate credit cards, executive dining, no- or low-cost loans, outplacement assistance, qualified employee discounts, spousal and dependent life insurance, transportation, employer-paid parking, relocation expenses, noncommercial air travel, employer-paid vacations, and wealth management services.

The road ahead

If your company offers any of these benefits, now is a good time to review your program in light of the IRS guidance. Otherwise, the road ahead could be a bumpy one filled with a tax audit and penalties.

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