In-Depth Review Of Important Tax Matters.

Disclaimer: MustardHub LLC and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Gift vs. Income

Under Internal Revenue Code (“IRC”) sec. 102(c) any amount transferred by or for an employer to or for the benefit of an employee is not a gift excludible from the employee’s income. Instead, those amounts are assumed to be compensation and are excludible only if they qualify as prizes and awards or de minimis fringe benefits. Extraordinary transfers to the natural objects of one’s bounty will not be considered transfers for the benefit of an employee if it can be shown that the transfer was not made in recognition of the transferee’s employment. Accordingly, Section 102(c) does not apply to amounts transferred between related parties (e.g., father and son) if the purpose of the transfer can be substantially attributed to the familial relationship of the parties and not to the circumstances of their employment. Similarly, a payment made to a former secretary was a gift and not compensation. The primary reason for the payment was affection, respect, and admiration.

The amount transferred will not be taxed if it can be shown it’s not in recognition of the recipient’s employment. Therefore, an amount provided to members of an association or group for some reason not related to an employment relationship is not taxable. Workers who receive awards not relating to their work will not be taxed on such amounts. Workers who receive awards directly related to compensation or work efforts will have those amounts taxed.

Further, he amounts are not taxable if there is a familial relationship between parties or made for the reasons of affection, respect, and admiration. Workers who receive awards as gifts, appreciation, loyalty, or simple recognition are not taxed.

Prizes and Awards – IRC sec. 74 generally requires the inclusion in gross income of all amounts received as prizes and awards. There are three major exceptions to the general inclusion rule. First, amounts excluded from income under Section 117 as scholarship or fellowship grants do not fall within the purview of the Section 74 inclusion. Second, a limited exclusion is available for awards to employees for length of service or safety achievements. Third, prizes and awards for charitable, scientific, artistic, and similar achievements are excluded if certain criteria are met and the winner assigns the prize or award to a charitable or religious organization.

All prizes and awards that do not satisfy the requirements of the exclusion for employee achievement awards are taxable to a recipient in the year in which received. However, nonemployee achievement awards for recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement are excludable if the following requirements are met: 1) the prize was given primarily in recognition of past achievement in certain fields; 2) the recipient was selected without any action on his or her part to enter the contest or proceeding; 3) the recipient is not required to render substantial future service as a condition of receiving the prize or award; and 4) the prize or award is transferred by the payor to a governmental unit or charitable organization.

More generally, the treatment of employee achievement awards is driven more by the value than the reason for the award. Gross income does not include the value of an employee achievement award if the cost of the award to the employer does not exceed the amount allowable as a deduction for the cost of the award. There are two parts to the annual limit on an employer’s deduction for the cost of an employee achievement award made to particular employee. Awards to a single employee cannot exceed $400 during a year, while the total awards to a single employee, under all plans, cannot exceed $1,600. Interestingly, the limitations on the employer’s deduction are measured by the employer’s cost, not fair market value, of the property awarded. The exclusion is based on the value of the award. Thus, an employee may exclude more than the $400 limitation provided the award’s cost was deductible by the employer. (For example, Employee A receives a watch as a length of service award from Corporation B, her employer. B makes no other awards to A in that year or in any of the four preceding years. If the cost to B of the watch is $350 and the fair market value is $450, B may deduct the entire $350 and A may exclude the entire $450 fair market value from income.).

Fringe Benefits – Fringe benefits are generally included in income as compensation for services. However, certain fringe benefits provided by an employer are excluded under IRC sec. 132 from the recipient-employee’s gross income for Federal income tax purposes and from the wage base for purposes of income tax withholding, FICA, FUTA, calculation of the Social Security benefit base, and the Railroad Retirement Tax. Any fringe benefit that does not qualify for exclusion under this provision and that is not excluded under another specific statutory provision is includible in the recipient’s gross income under IRC sec. 61 and 83.

Benefits excludible under Section 132 are:

  1. no-additional-cost services;
  2. qualified employee discounts;
  3. working condition fringes;
  4. deminimis fringes;
  5. qualified transportation fringes; and
  6. qualified moving expense reimbursements.

Membership inclusion costs, discounts or trivial amounts for working conditions or qualified transportation costs are not taxed. If a company adds a member as premium (value = $5/mo) this would not be taxed. It is an inclusion cost and also trivial.

Valuation

When remuneration is paid in items other than cash, the remuneration is computed on the basis of the fair value of the items at the time of payment. IRC sec. 61 and 74 and the regulations thereunder contain rules that apply when an employer transfers a noncash prize to an employee. Regs. Sec. 1.61-2 provides that if property is transferred by an employer to an employee as compensation for services for an amount less than its fair market value, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its FMV at the time of the transfer is compensation and is included in the gross income of the employee. Similarly, Sec. 74 and the regulations thereunder provide that if a prize or award is made not in money but in goods or services, the amount to be included in income is the FMV of the goods or services. “Fair market value” means “the amount that an individual would have to pay for the particular benefit in an arm’s length transaction.” The IRC sec. 61 regulation specifically states that an employee’s subjective perception of the value of a benefit is not relevant to the determination of the benefit’s FMV.

Timing

The cash equivalency doctrine essentially provides that if a promise to pay a benefit to an individual, even though unfunded, is unconditional and exchangeable for cash, the promise is the equivalent of cash and is currently taxable. The IRS appears to view award programs as cash equivalents (e.g., taxable upon receipt). In Rev. Rul. 70-331, a distributor issued “prize point checks” redeemable for merchandise to employees of his dealers. Each employee selected the merchandise award he desired and sent an order form together with sufficient prize point checks to cover the order to the distributor. The merchandise award was sent directly to the salesman. The ruling held that the fair market value (FMV) of the prize points was includible in the employees’ gross income at the time the prize points were paid or otherwise made available to them, whichever was earlier.

On the other hand, if employee reward programs are not funded the result may be different. For example, employers might not contribute cash to an “employee award trust” at the time points are granted to employees so that funds can be accumulated to satisfy the obligation when the employee later redeems the points; rather, the employer purchases the prizes only after the employee selects the merchandise for which the points are to be redeemed. In this scenario, until such time as they are redeemed for prizes, the points would appear to constitute an unfunded and unsecured future promise by the employer to pay, so points awarded under an employee reward program might not be taxable under the rules of IRC sec. 83.

Withholding

Sec. 3401(a) provides that for income tax withholding purposes, “wages” means all remuneration for services performed by an employee for his or her employer. Sec. 3121(a) defines the term for FICA purposes as all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash (with certain specific exceptions not here applicable). Thus, once the employer has determined the time and amount of taxable compensation, it is required to withhold taxes on such compensation. In most instances, employers will withhold the taxes attributable to the prize awards by reducing the employee’s cash compensation. This reduction in take-home pay can be problematic for many employees, particularly when the amount of the noncash reward is significant.

The IRS has issued withholding and reporting guidelines for taxable noncash fringe benefits that give employers significant flexibility in determining when the value of noncash fringe benefits should be included in income and subject to withholding. Announcement 85-113 31 permits employers to elect, for employment tax and withholding purposes, to treat fringe benefits as paid on a pay period, quarterly, semiannual, annual, or other basis, provided the benefits are treated as paid no less frequently than annually. Employers do not have to make the same election for all employees. Therefore, the employer may withhold more frequently for some employees than for others.