Rounding the bend on our series of five alerts highlighting some common pitfalls for closely-held businesses and their benefits and compensation arrangements, this alert (fourth in the series of five) dives into the world of perquisites (often called “perks” or “fringe benefits”).
In case you missed or want to revisit the first three alerts in our series (addressing health insurance, 401(k) plans and administrative “gotchas”, respectively), you can find them here, here and here.
So, the company may be doing the “right thing” and offering some benefits – or even a comprehensive benefit package – to its “rank and file” workforce, but that doesn’t mean the family member owners and/or other executives or key management members aren’t otherwise benefitting. To the contrary, most closely-held and family-owned businesses maintain a litany of perks adopted to enhance the package made available to those “key” groups. We commonly think of club memberships, company cars and private jet excursions, to name a few. While executives may come to expect these perks as part of their compensation package, these perks don’t come without the need for careful vetting of certain tax and compliance considerations:
Is it Includible in Taxable Income?
- The starting place in answering this question is Internal Revenue Code Section 61. That Code Section states, in relevant part, that “Gross income means all income from whatever source derived, including (but not limited to) . . . [c]ompensation for services, including fees, commissions, fringe benefits, and similar items.”
- Unless another Code provision carves out a “perk” from the definition of gross income, it is included. That fact notwithstanding, many executive perks are not taxed without any meaningful consideration of why the executive should benefit from such a gross income exclusion.
- A few examples:
- A company provided cell phone. Provision of such a phone will be excluded from gross income and exempt from employment tax withholding if provided primarily for noncompensatory business purposes. Here, even de minimis personal use is ignored.
- On-site meals. While, generally speaking, an employer can exclude from income the value of de minimis meals provided to an employee, an employer is precluded from excluding from the wages of a highly compensated employee the value of meals provided at an employer-operated eating facility IF that meal isn't available on the same terms to all employees or a group of employees defined under a reasonable classification that doesn't favor highly compensated employees.
- Personal travel on a company’s private jet. This personal use is also considered a fringe benefit provided to the employee or owner in which income almost always needs to be imputed to the individual, or reimbursed, for use of the plane.
- REMEMBER: When the value of the perk/fringe benefit is NOT included in income, there should be a sufficient legal basis found in a particular provision of the Internal Revenue Code (or supplementary IRS guidance) indicating that there’s an exclusion for that specific purpose.
Is it Deferred Compensation?
- After determining whether a perk should be included in gross income, determining whether it is/may be “deferred compensation” under Internal Revenue Code Section 409A is necessary.
- Typical Examples of Arrangements Covered by 409A:
- Split dollar life insurance plans;
- Excess deferred compensation and “wrap” plans (plans that provide for deferrals in excess of statutory limits such as the limitation on employee deferrals under a 401(k) plan);
- Incentive deferral plans;
- 457(f) deferred compensation plans (for tax-exempt entities);
- Phantom stock plans and stock appreciation right plans;
- Restricted stock plans;
- Deferred compensation arrangements for board of director members or for consultants;
- Taxable welfare benefits;
- Certain perks (use of car; country club payments; internet connection; cell phone use);
- Some severance plans;
- Employment agreements that contain any provisions deferring compensation;
- Bonus plans that include deferral features or that are paid more than 2½ months after the year for which the bonus is granted; and
- Stock options granted at less than fair market value.
- Oftentimes perks are paid in the form of a reimbursement (e.g., submitting a paid invoice for club membership to be repaid to the executive). While the company is likely to have a reimbursement policy in place, whether that policy complies with Internal Revenue Code Section 409A is another story.
- Code Section 409A generally requires that expenses eligible for reimbursement be objectively determinable and reimbursed within a limited period of time following the date in which the expense is incurred.
- The rules on reimbursement are numerous and include (but are not limited to): the requirement that all reimbursements must occur by the end of the taxable year following the year in which the expense was incurred; and the requirement that the amount of reimbursements in one year not affect another year. That last requirement is often the biggest stumbling block for employers.
- Consider, for example, a multi-year (say, for our purpose, two years) employment agreement that limits reimbursable expenses for club membership over the life of the agreement (rather than on an annual basis) to $50,000. This multi-year reimbursement provision violates Code Section 409A. If the employee incurs and submits reimbursement for $30,000 in expenses in the first year of the contract, the amount eligible for reimbursement in the second year is necessarily affected (i.e., reduced to $20,000 from $50,000). Similar 409A reimbursement problems would arise for a specified reimbursement amount that applies to a non-calendar contract year (for example, “during the first year following hire”) in an employment agreement.
Look before you leap…. While the boss may have certain ideas or expectations about what s/he will receive in terms of perks, carefully considering the tax treatment of all perks/fringe benefits is essential. Word that an IRS audit has unearthed some or many incorrectly taxed benefits is unlikely to be favorably received by owners/management so it’s best to avoid potential issues wherever possible. That said, if there are failures in this regard, it may be possible to correct them; however, as with most corrections, corrections under 409A for identified problems and sooner corrections of underreporting (and/or under-withholding) are subject to more favorable corrections when corrected sooner than later.