Do you want to be extra-generous to employees who are doing a good job? Bonuses and gifts can be an effective motivational tool, but just be aware of all the tax consequences. Usually, the employees will face a tax bill for your generosity.
Background: Unlike gifts made on a personal level, gifts from an employer to employee (outside the context of employment) are generally taxable to the recipient as supplemental wages. In other words, the gifts are subject to both income tax and employment taxes. The value of the gifts must be reported on the employee’s Form W-2 for that year.
In contrast, gifts from one individual to another are not taxable to the recipient. Annual gifts of up to $14,000 per recipient are exempt from gift tax implications under the gift tax exclusion (unchanged from 2016).
What if a supervisor gives a personal gift to an employee?
Decades ago, in a landmark case, the U.S. Supreme Court established that a transfer only constitutes a tax-free gift if it is made through “detached and disinterested generosity” or “out of affection, respect, admiration, charity or like impulses.” (Duberstein, 363 U.S. 278, 1960)
In that case, an individual taxpayer gave the names of potential customers to a company that he often did business with. The information turned out to be valuable and the company rewarded the taxpayer with a Cadillac automobile. The company later deducted the cost as a business expense on its corporate tax return.
Meanwhile, the taxpayer did not include the value of the car in his income because he considered it a gift. However, the Supreme Court ruled that the transfer was not a gift but was a payment for “past services, or an inducement for him to be of further service in the future.”
It is usually difficult to prove in the context of an employer-employee relationship that a gift was given with no business purpose.
In one U.S. Tax Court case, a taxpayer worked as the president of an electronics manufacturing company in Seattle, Washington. She received a payment of $160,000 from the company and claimed the money was a gift from the owner, who was a “close acquaintance.” The company reported the amount to the taxpayer and the IRS as miscellaneous income on a Form 1099.
Payments from an employer to an employee are generally includable in gross income. However, it is not impossible for a payment from an employer to an employee to be considered a gift given for personal reasons if it “is completely unrelated to the employment relationship and reflects no expectation of a business benefit,” the Tax Court stated.
However, the court found the $160,000 payment resulted from the owner’s efforts to encourage a valued employee to remain with the company. The facts suggest it was “motivated by business exigencies and not by detached or disinterested generosity.” Therefore, the payment constituted taxable income. (Larsen, TC Memo 2008-73)
Note that certain minor or “de minimis” amounts provided to employees, such as the use of the company’s copying or fax machine, aren’t considered taxable wages. These perks are tax-free to employees. But any amount of cash or a comparable gift is not be treated as a de minimis fringe benefit. Thus, if an employer gives an employee a $50 gift card for a store at the local mall, the employee must report the $50 “gift” as taxable income.
Another Exception: Employee Achievement Awards
In some cases, the value of employee achievement awards can be excluded from taxable income but there are strict rules that must be followed. The award must be an item of “tangible personal property” and not involve cash, a gift certificate, or other cash-equivalent item. It must also be given for length-of-service or safety achievement. The amount that the employee can receive tax free under this exception is limited to the employer’s cost and cannot exceed $1,600 ($400 for awards that are not qualified plan awards) for all awards the employee receives during the year.
In addition, the employer must make the award as part of a meaningful presentation. The tax-free employee achievement award exception does NOT apply if:
- The length-of-service award is for less than five years of service or if the employee received another length-of-service award during the year or the previous four years.
- The safety achievement award is given to a manager, administrator, clerical employee, or other professional employee.
- More than 10 percent of eligible employees previously received safety achievement awards during the year.
Strings Attached to Some Business Gifts
The specific tax rules are different for gifts that a business gives to a vendor, supplier or customer.
Basic premise: The business can deduct business gifts of up to $25 per person per year. This includes both direct and indirect gifts. For instance, if you give a gift to a customer’s spouse or child, it is considered to be an indirect gift to the customer. If you give gifts to a select group of a company, the gifts are treated as being made to the individuals within that group.
The annual limit per person is relatively low, but at least you don’t have to count incidental costs or gifts of a minimal value (such as coffee mugs or pens costing $4 or less). Special rules apply to tickets that may qualify as business entertainment.
Practical advice: Consult with your tax advisor and coordinate gift-giving activities with your payroll department when they involve employees. Make sure that gifts reflect the strict letter of the tax law.
Explain Tax Implications: Don’t Let Incentive Programs Backfire
An employee’s delight over a fringe benefit or bonus can be soured after being hit with an unanticipated tax bill.
Most of the time, it’s easy to explain that perks, such as a bonus or the use of a company car, are treated as income and subject to taxes.
Stock options are more complicated to explain. As this incentive moves down to lower employee ranks, it reaches younger or less financially knowledgeable employees who are generally least able to afford the taxes and most likely to misunderstand how to exercise options advantageously.
Rather than viewing options as a long-term incentive to stay with a company, many employees believe options have immediate cash value that goes up over time. Some employees are stunned when they exercise their options at and incur a large tax bill. Other employees who exercise at the wrong time or during a down market may owe more in taxes than they made on the stock.
Worst case: A staff member faced with an unanticipated tax bill blames the company.
If your company offers stock options or other valuable benefits as incentives, don’t let them backfire through misunderstanding. A few tips:
1. Offer education classes shortly after hiring.
2. Explain the implications of benefits upfront so employees are clearly informed about their risks and rewards.
3. Inform employees when fringe benefits are tax-free. For example, the cost of up to $50,000 of group-term life insurance coverage provided by an employer is not included in income. Check with your tax pro for details.
Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.