A—Taxation of Employee Benefits

Employee benefits, once considered an “addition” to wages, have now become an integral part of virtually all compensation packages. This overview evaluates the tax attributes of various employee benefit plans

Characterization of a benefit as either bad, better, or best, can be made according to its effect upon the income taxes of the employer and the employee. Because of reductions in the top C corporate marginal tax rate from 34 percent to 21 percent and a much smaller reduction (actually an increase for some taxpayers) in the individual tax rates – the analysis of various employee benefits has changed since the 2017 Tax Act. In 2017, you could use an example where we had an employer in a 34 percent marginal tax bracket and an employee in a 25 percent tax bracket. However, for the first time in recent memory, it is possible (if not likely) for the corporate income tax rate to be less than the individual income tax rate. For this reason it is very important to consider relative tax brackers when considering employee benefit planning.

Today, the analyis will be done with a 21 percent employer rate and a 25 percent employee rate

BAD. A bad employee benefit is one that is nondeductible to the employer yet taxable to the employee, such as one that results in unreasonable compensation or is treated as a dividend. Because it is nondeductible, on each $1.00 of income the employer must pay 21 cents in taxes (34 percent in 2017). Since the remaining 79 cents is taxable to the employee, 20 cents of employee taxes will further reduce the original $1.00 to only 59 cents (49 cents in 2017). So while reductions in corporate tax rates make nondeductible benefits less inefficient – it is still prudent to avoid this tax treatment in most instances.

BETTER. A better employee benefit is one that is deductible to the employer, although still taxable to the employee. Since there are no employer taxes, the full $1.00 is taxable income to the employee. Now 25 cents goes to pay employee taxes, and the remaining 75 cents actually benefits the employee. With little change to the individual income tax rates as a result of the 2017 Tax Act, this analysis remains mostly unchanged from 2017.

Better benefits include salary allotment plans, executive equity plans, split-dollar insurance, survivor income plans, disability income plans, and deferred compensation.

BEST. The best employee benefit is one that is deductible to the employer and either nontaxable or tax deferred to the employee. Now the entire $1.00 benefits the employee, without any current reduction for either employer or employee taxes. That's the best!

“Best” benefits include group term insurance, medical expense reimbursement plans, SIMPLE IRAs, and qualified retirement plans, including 401(k) plans. Specific benefits may not be available to all employees and employers. Although SIMPLE IRAs and qualified retirement plans, including 401(k) plans, are listed among the “best,” it must be recognized that the employee pays taxes when retirement income is actually received. Tax-free group term insurance is limited to $50,000 of coverage. The term “leveraged benefit” can be used to describe some of the best employee benefits.