Monthly Archives: April 2015

Deducting Employee Benefits: An Overview

If you have employees, you are undoubtedly aware that you can claim a business expense deduction for the wages and salaries that you pay them. However, you may not be aware that other benefits that you provide can be deducted. For example, if you give your employees a discount on the cost of your goods or services, or if you provide paid holidays or vacations, then you have provided a deductible benefit.


Employee Benefits Can Be Taxable or Nontaxable

The deductibility of an expense by the employer is a different issue than the taxability of the benefit to the employees. (And in some cases, the cost to the employer and the value to the employee are not the same, at least in the eyes of the IRS.)

Some types of benefits are not taxable for payroll tax purposes. These benefits are not taxable to the employee for FICA or income tax withholding purposes, and they are not taxable to you for FICA or FUTA tax purposes.

Common examples of this type of benefit are health insurance, qualified retirement plan contributions, and group-term life insurance up to $50,000. Even if the benefit is not taxable to the employee, you can still deduct the cost of providing the benefits, provided that you meet all the requirements.

The value of fringe benefits that are not tax-free under the Internal Revenue Code must be included in the employee’s taxable income. This is also true when the benefits are of a type that would be excludable if they met all the federal requirements, but for some reason your plan does not meet the requirements.

For instance, some types of retirement plans are not permitted to discriminate in favor of highly compensated employees such as the business owners. If the plans do discriminate, the value of the benefits will generally be taxable compensation to the highly compensated employees who receive them. 

Again, the fact that the value of the benefit must be included in the employees income is a separate issue than whether you can deduct the cost of providing the benefit. The cost of the benefit is still deductible by you.

For example, if you let your sales representatives use a company car, the value of this noncash fringe benefit must be included in the sales representative’s wages as part of his or her compensation. You will not be able to deduct the value of this fringe benefit as a wage expense. However, you can deduct your costs of providing the cars, including the depreciation expense.

Retirement Contributions May Be Deductible

One of the best ways to reduce your tax bill, while increasing your net worth and future security, is to invest in a retirement plan. When you own the show, you’re in a position to tailor-make a plan that suits your needs precisely. If you set up a plan that meets the IRS requirements, you can make tax-deductible contributions to the plan, which will build up tax-free until you withdraw them.

As a self-employed business owner, your major retirement plan options are:

  • Keogh plans. Defined benefit, defined contribution, or hybrid retirement plans set up by a self-employed person or partnership. Common types of Keoghs include money-purchase plans and profit-sharing plans.
  • Simplified Employee Pensions (SEPs). A very flexible, easy plan to set up that involves making contributions to special Individual Retirement Accounts (IRAs) set up for the business owner and each eligible employee.
  • SIMPLE plans. The Savings Incentive Match Plan for Employees (SIMPLE plan), which allows employees to make elective contributions of up to $12,000 in 2013 and 2014), and requires employers to make matching contributions.
  • Individual Retirement Accounts (IRAs). The easiest solution to retirement savings, although your contributions are limited to $5,500 in 2013 and 2014) (Those who are age 50 and above can contribute an additional $1,000.)

Work Smart Small employers 100 or fewer employees can claim a tax credit of 50 percent of the start-up costs incurred to create or maintain a new employee retirement plan for the first three years of the plan. The amount claimed is limited to $500 in a tax year.

Reporting Plan Contributions Varies Based Upon the Plan

If you are a sole proprietor, contributions made for employees to a Keogh plan, an SEP, or a SIMPLE plan are reported on Line 19 of Schedule C, “Pension and profit-sharing plans.” Contributions made to the plan on your own behalf would be reported on Line 28 of your Form 1040.

There are also some special tax reporting requirements with regard to the Keogh or other retirement plan itself. Generally, an annual report on IRS Form 5500-C/R (for plans with fewer than 100 participants) must be filed with the IRS by the last day of the 7th month after the close of the plan year. Single-participant plans can use Form 5500-EZ. See the instructions for these forms (available from the IRS by calling 1-800-TAX-FORM, or at its website or see your professional tax advisor.

If your IRA contribution is deductible, you don’t need to file any special forms to claim it, nor do you need to itemize your deductions on Schedule A of Form 1040. Simply write the amount of your contribution (and your spouse’s contribution, if married filing jointly) on Line 32 of Form 1040, or Line 17 of Form 1040A. To report any nondeductible IRA contributions, you must file IRS Form 8606, Nondeductible IRAs, with your tax return. To claim a tax credit for your retirement contributions, if you are eligible, you must file IRS Form 8880, Credit for Qualified Retirement Savings Contributions,.

Accountable Plans Provide Significant Benefits When Reimbursing Employees

If your employees pay business expenses from their own funds, you will generally want to reimburse them for these expenses. It is important to be aware of, and follow the rules, when making the reimbursement or you could cost yourself a business expense deduction and trigger additional income for your employees.

You will want to make sure that the reimbursements, particularly for automobile, travel, meals and entertainment expenses, are made under an “accountable plan.” 

Expenses reimbursed under an accountable plan are deductible as business expenses and are also excluded from the employee’s gross income. If you are a sole proprietor filing Schedule C, you would deduct these reimbursed expenses in the Schedule C categories to which they pertain. So, reimbursed employee travel expenses would be added to your own travel expenses on Line 24a; reimbursed meals would be reported on Line 24b etc.

Reimbursements under nonaccountable plan. However, if the reimbursements are not made under an accountable plan, you must include the reimbursements in the employee’s wages on IRS Form W-2. In addition, you have to withhold income taxes and employment taxes on reimbursements made, or considered made, under a nonaccountable plan and you have to pay the employer’s portion of the payroll taxes

The employee will have to report the reimbursement as income and must must generally claim a miscellaneous itemized deduction for the allowable business expenses if he or she wants to get any tax benefits from them. This is a harsh result for the employee because it requires that the employee itemized deductions and the miscellaneous itemized deductions are subject to a two-percent income floor. If you are a sole proprietor, you’d include the reimbursements on Line 26 of Schedule C, “wages.”

What Is an Accountable Plan?

Clearly, reimbursing under an accountable plan is better for both you and your employees, from a tax perspective. So, what is an accountable plan? A reimbursement arrangement that meets the following three requirements is considered an accountable plan:

  1. The reimbursements must be for deductible business expenses that are paid or incurred by an employee in the course of performing services for you.
  2. The employee must be required to substantiate the amount, time, use, and business purpose of the reimbursed expenses to you. In order to do this, the employee should submit an account book, diary, log, statement of expense, trip sheet, or similar record, supporting each of these elements, that is recorded at or near the time of the expenditure. The records should include any supporting documentary evidence, such as receipts. An employee who receives a mileage allowance is considered to have substantiated the amount of the expenses if the employee substantiates the time, place (or use), and business purpose of the travel.
  3. The employee must be required to return to you any excess of reimbursements over substantiated expenses within a reasonable period of time.

How long is a “reasonable period?” The IRS will generally accept your plan if the employee is required to provide substantiation within 60 days or return unsubstantiated amounts within 120 days after an expense is paid or incurred. If you furnish your employees with periodic statements (not less frequently than quarterly) of unsubstantiated expenses, amounts substantiated or returned within 120 days of the statement will be considered returned or substantiated within a reasonable time.

You can use a mileage allowance – even one that exceeds the standard mileage rate – and if it is reasonably calculated not to exceed the employee’s actual or anticipated expenses, it will be treated as meeting this return requirement even if the employee does not have to return the excess of the allowance over the standard mileage rate.

Is all this recordkeeping worthwhile? The major financial advantage to having an accountable plan is that you are not required to pay the employer’s portion of FICA taxes on reimbursements. The plan also will increase your employees’ satisfaction with you because they will not have to pay taxes on the amounts, or deduct them on their own tax returns. 

In contrast, if you don’t meet the requirements for an accountable plan, you will have to withhold income taxes and employment taxes on any reimbursements you make. While an accountable plan is not required, it could be a real money saver in the long run depending on how many employees you have and the extent to which reimbursement plays a part in your business.

Special Rules Apply to Employer-Provided Meals, and Lodging

If you pay your employees in the form of food or housing, you can deduct your actual costs of providing these items. You would deduct them as direct costs of your business, not as employees’ wages.


If you are a sole proprietor and you rent a house for your temporary workers to live in, you can deduct the cost of the rental payments as “rental expenses” on Line 20b of your Schedule C, not as “wages” on Line 26.

Meals for employees. Special, more restrictive rules for meals state that only 50 percent of the costs of meals provided to employees are deductible, unless the value of the meals is included in the employees’ taxable wages.

However, certain free meals provided to employees for the convenience of the employer are 100 percent deductible by the employer and are not taxable to the employees. To be considered “for the convenience of the employer,” they must be taken on the business premises.

Work Smart – You can deduct the full cost, not just 50 percent, of providing an occasional social or recreational event for your employees, such as a company picnic or holiday party.

If an employer provides meals to its employees on the premises and more than one-half of the employees are receiving the meals “for the convenience of the employer,” the meals will not be taxable to any of the employees and the employer can deduct the entire cost of all the meals. The question of exactly what “convenience of the employer” means remains an unsettled question in the law. Generally, if your employees must remain on the premises in order to be available to work if needed, or if the lunch breaks are too short to allow employees to go out to eat, the meals would be considered to be for the employer’s convenience.




Protect Your Small Business

If you own a small business, it might seem like there are an infinite number of ways you can get in trouble with the government. This is not quite true—the number is not infinite. Here are the four most common ways small businesses get into truly serious legal trouble with the government.

1. Failing to Pay Payroll Taxes to the IRS

Whenever you hire an employee for your business, you become an unpaid tax collector for the IRS. You are required to withhold and pay to the IRS your employees’ income taxes. You are also required to withhold and pay their Social Security and Medicare taxes and make a matching contribution out of your own funds. You must pay these taxes to the IRS throughout the year—smaller employers usually pay them monthly.

As far as the IRS is concerned, an employer’s most important duty is to withhold and pay Social Security, Medicare and income taxes. These are also known as “trust fund taxes” because the employer is deemed to hold the withheld funds in trust for the U.S. government. If you fail to pay trust fund taxes, you can get into the worst tax trouble there is. The IRS can—and often does—seize a business’s assets and force it to close down if it owes back payroll taxes. Although rare, you can also get thrown in jail.

At the very least, you’ll have to pay all the taxes due plus interest. The IRS may also impose a penalty known as the trust fund recovery penalty if it determines that you willfully failed to pay the taxes. The agency can claim you willfully failed to pay taxes if you knew the taxes were due and didn’t pay them. If you paid such taxes in the past and then stopped paying them, that constitutes pretty good evidence that you knew the taxes were due.

The trust fund recovery penalty is also known as the 100% penalty because the amount of the penalty is equal to 100% of the total amount of taxes the employer failed to withhold and pay to the IRS. This can be a staggering sum.

If you’re a business owner, you’ll be personally liable for the 100% penalty—in other words, you will have to pay it out of your own pocket. Business owners include sole proprietors, general partners, and corporate officers such as the president, vice president, secretary, and treasurer, whether or not they own any stock.

Small businesses that are starved for cash sometimes “borrow” the taxes they are supposed to withhold and pay to the IRS. Obviously, this is insanely stupid. It is the absolutely last thing any business owner should ever do.

To make sure all your payroll taxes are filed properly and on time, it’s wise to use the services of a reputable payroll tax service. The cost will be quite small if you only have a few employees. You can find a list of payroll service providers on the IRS website at Your bank may also provide payroll tax services.

Be aware, however, that even if you use a payroll tax service, you remain personally liable if your taxes are not paid on time. The IRS recommends that an employer: (1) keep its company address on file with the IRS, rather than the address of the payroll service provider, so that the company will be contacted by the IRS if there are any problems; and (2) contact the IRS about any bills or notices you receive as soon as possible. This is especially important if it involves a payment you thought your payroll service already made.

2. Misclassifying Workers as Independent Contractors

You can avoid having to pay payroll taxes to the IRS by classifying a worker as an independent contractor, instead of an employee. Independent contractors are not entitled to any of the benefits that employers are usually required to provide employees, including workers’ compensation insurance coverage, unemployment insurance, or health insurance (required by Obamacare starting in 2015 for employers with over full-time 50 employees).

However, a worker is not an independent contractor simply because you say so or he or she signs a piece of paper saying so. The worker must actually be in business for himself or herself. A worker who is solely dependent on you for his or her livelihood and subject to your direction and control on the job, is your employee, no matter what label you use.

A common way small business owners get into trouble with the government is misclassifying workers as independent contractors to avoid their responsibilities as employers. Federal and state agencies are well aware of this problem, and worker misclassification is a hot button issue for them. These agencies include the IRS, state unemployment insurance agencies, and workers’ compensation agencies. Because these agencies share information with each other, misclassifying workers as independent contractors can lead to a cascade of government audits, resulting in costly assessments that can put you out of business. For this reason, you need to take great care when you determine whether to classify a worker as an employee or independent contractor, and properly document your actions. For details, see the article Hiring Employees and Independent Contractors.

State unemployment insurance agencies

The worker misclassification issue most frequently arises when a fired or laid off worker who has been classified as an independent contractor files a claim for unemployment compensation, claiming he or she should have been treated as an employee for unemployment insurance purposes. When this happens, state unemployment auditors will investigate the hiring firm. If the state auditors determine the worker should have been classified as an employee, they will require the company to pay all the unemployment taxes it should have paid for the worker going back several years—three years is common— plus interest. In addition, auditors usually impose penalties for the misclassification. To add insult to injury, if other workers do similar work for the same company, the employer will have to pay UI taxes for those employees
as well. The misclassified employees will also be eligible for workers’ compensation benefits and any fringe benefits the company provides its employees such as overtime, health insurance, and retirement plans.

State workers’ compensation agencies

Unemployment insurance audits can also lead to audits by your state workers’ compensation agency. They also frequently occur when a worker who is injured on the job files a workers’ comp claim. You will suffer harsh penalties if you misclassify an employee as an independent contractor for workers’ compensation purposes and have no workers’ compensation insurance.

Most state workers’ compensation agencies maintain a special fund to pay benefits to injured employees whose employers failed to insure them. You will be required to reimburse this fund or pay penalties to replenish it.
In addition, in most states, the injured worker can sue you in court for personal injuries. Most states try to make it as easy as possible for injured employees to win such lawsuits by not allowing you to raise legal defenses you might otherwise have, such as that the injury was caused by the employee’s own carelessness.
You will also have to pay fines imposed by your state workers’ compensation agency for your failure to insure. The workers’ compensation agency may also obtain an injunction—a legal order—preventing you from doing business in the state until you obtain workers’ compensation insurance.
Finally, in almost all states, failure to provide employees with workers’ compensation insurance is a crime—a misdemeanor or even a felony. An uninsured employer may face criminal prosecution, fines, and, in rare cases, prison.


Worker classification is also an issue frequently explored in audits of small businesses by the IRS. If the IRS conclude that you have misclassified employees and independent contractors, you’ll have to pay back taxes, interest, and penalties. The assessments the IRS can impose for worker misclassification vary, depending upon whether the IRS views your misclassification as intentional or unintentional. If the IRS determines you unintentionally misclassified a worker for whom you filed all required 1099 forms, you’ll have to pay about 20 cents for every dollar you paid the worker, and 25 cents for every dollar if you didn’t file 1099 forms. But if the IRS finds your misclassification intentional, you’ll have to pay about 50 cents for each dollar you paid the worker.

3. Violating Federal and State Labor Laws

Employees enjoy a wide array of rights under federal labor and antidiscrimination laws. Among other things, these laws:

  • impose minimum wage and overtime pay requirements on employers
  • make it illegal for employers to discriminate against employees on
    the basis of race, color, religion, gender, age, disability, or national
    origin, and
  • protect employees who wish to unionize.

Most states have similar laws protecting employees.

In recent years, a growing number of employees have brought lawsuits against employers alleging violations of these laws. Some employers
have had to pay hefty damages to their employees. In addition, various watchdog agencies, such as the U.S. Department of Labor and the U.S. Equal Employment Opportunity Commission, have authority to take administrative or court action against employers who violate these laws.

Most of these laws, other than some nondiscriminination laws, apply only to employees, not independent contractors. If you have employees, you need to understand and follow these rules. For more information, refer to the United States Department of Labor elaws web page (short for employment laws assistance for workers and small businesses).

4. Violating Federal Immigration Law

Many workers in the United States are immigrants. And some of these immigrants work illegally—that is, they are not U.S. citizens and don’t have a green card or other documentation of their legal status. All employers must verify that their employees are either U.S. citizens or nationals, or legal aliens authorized to work in the U.S. To do this, the employer and employee must complete USCIS Form I-9. The employee must provide identifying information and documents establishing the employee’s citizenship status, such as a driver’s license, Social Security Card, or U.S. passport. The form must be kept by the employer, but need not be filed by with the government.

You are not required to verify citizenship when you hire an independent contractor. However, although you are not required to verify the immigration status of ICs or others coming within these exceptions, it is still illegal for you to hire any worker whom you know to be an illegal alien. The federal government can impose a fine of up to $2,000 for the first offense.