Fringe benefits and payroll: What's taxable and what isn't

Offering employee benefits, in addition to regular compensation, can help a growing company attract talent and support its team. But these perks, sometimes known as “fringe benefits,” can be complicated to navigate when it's time to run payroll.

So, if you’re wondering, “What are fringe benefits in payroll, exactly, and how do they affect the taxes employers pay?” we’ve got you covered. Here, we dive into the answers and untangle the ways that the Internal Revenue Service (IRS) treats compensation beyond regular wages.

Fringe benefits are forms of compensation that an employer provides to employees in addition to their regular pay. These benefits could include:

• Health insurance
• Retirement contributions
• Transportation assistance
• Personal use of company property

When running payroll, you’ll need to understand whether the IRS considers a benefit to be taxable compensation. If a benefit is considered to be taxable, as the employer, you must include its value in the appropriate wage calculations, even when the employee receives no additional cash. (More on this in the following sections.)

IRS rules around fringe benefits treat these perks as taxable unless a specific exclusion applies. Employers should evaluate each benefit — and don’t assume that every employee perk will be eligible to receive favorable tax treatment.

A benefit may qualify for an exclusion from federal income tax withholding but still be subject to Social Security or Medicare taxes, for instance. Eligibility may also depend on the employee's role, the benefit's value, or how the employer administers it.

The tax treatment of fringe benefits can vary widely, even among perks that seem similar. Some benefits qualify for tax exclusions, meaning that the value of the benefit doesn’t count as taxable income. Other benefits are considered taxable income, and, therefore, require additional withholding or reporting (and the employee will be responsible for associated taxes).

Knowing which benefits are taxable, which may qualify for exclusions, and which conditions may apply can help you make informed decisions for your business and avoid payroll errors. Here's how some common employee benefits are treated for federal tax purposes.

Health, insurance, and retirement benefits

Health coverage, life insurance, and retirement benefits are some of the most common examples of fringe benefits. Here’s what you need to know when calculating payroll:

• Health coverage: Employers typically don't count qualifying employer-sponsored health coverage as taxable wages, although special rules apply to shareholders who own more than 2% of an S corporation.
• Life insurance: For group-term life insurance exceeding $50,000, employers calculate the taxable cost of excess coverage using IRS rules. That amount is subject to Social Security and Medicare taxes and specific Form W-2 reporting requirements.
• Retirement benefits: Retirement contributions also require care. Employees' traditional 401(k) salary deferrals reduce wages subject to federal income tax withholding but remain subject to Social Security and Medicare taxes.

Other benefits for employees

The circumstances surrounding a benefit will often determine its tax treatment. For instance:

• Meals: Meals that an employer provides at the office may qualify for an exclusion, while regular lunch stipends usually don't.
• Transportation: Qualified transit and parking benefits may receive favorable treatment within IRS limits. Ordinary commuting reimbursements outside those rules generally remain taxable.
• Company property: Employers can typically exclude qualifying business use of equipment, such as a laptop needed for work. However, personal use of an employer-provided vehicle will likely be considered taxable.
• Education: Qualifying programs allow employers to exclude up to $5,250 annually for eligible expenses, including certain student loan payments.
• Special company perks: Employee discounts, wellness programs, and achievement awards have separate requirements. For example, a cash performance bonus remains taxable, even if the employer calls it an award.
• Small benefits: De minimis benefits are small, occasional perks, such as holiday gifts of modest value or occasional refreshments, which would be unreasonable to account for individually.

Recap: Common fringe benefits and their tax treatment

Employers should clearly distinguish taxable employee compensation from ordinary business expenses and benefits that qualify for tax exclusions. Equipment needed for work, necessary protective gear, and qualifying business expense reimbursements, for instance, may be excluded from taxable wages under IRS rules for working-condition benefits and, depending on the arrangement, these costs may qualify as working-condition benefits or reimbursements under an accountable plan.

If you offer your employees perks, like memberships or cash allowances, they aren’t necessarily considered tax-exempt in the IRS’s view, just because you label them as benefits.

You may be wondering, “Are payroll taxes considered fringe benefits?” The answer is no, payroll taxes aren’t considered fringe benefits. Employer Social Security, Medicare, and unemployment taxes are statutory obligations, not employee perks.

For most taxable noncash benefits, the IRS uses fair market value (FMV) to measure the value. FMV is what someone would ordinarily pay for the benefit in the open market. Some benefits, including access to company vehicles and group-term life insurance, have specialized valuation rules.

As an employer, you’ll determine the fair market value for each fringe benefit, apply any relevant exclusion, and subtract eligible employee contributions. For example, if your company provides a personal-use benefit worth $600 and the employee contributes $150, the remaining $450 represents taxable compensation, when no exclusion applies.

Once you’ve determined a benefit's taxable value, the next step is to incorporate that amount into your company’s payroll and wage reporting-systems. To do so:

1. Calculate the benefit’s taxable value. Determine whether the benefit should be measured by its fair market value or a specialized valuation rule. Apply any exclusions needed. Then, calculate employee contributions.
2. Assess whether exclusions apply. Calculate any applicable exclusions, employee contributions, and valuation rules.
3. Determine which taxes apply. Depending on the benefit, you may need to calculate federal income tax withholding, Social Security, Medicare, and federal unemployment taxes.
4. Record the taxable amount in the appropriate payroll category. You’ll likely input this as income for noncash benefits, but don’t add cash that the employee hasn't actually received.
5. Report employment taxes. As an employer, you must also account for applicable employment taxes and report the required amounts on Form W-2.

When determining how to calculate payroll tax on fringe benefits, remember that withholding requirements vary by benefit. The IRS also permits certain choices about when to treat taxable noncash benefits as paid, subject to timing requirements. Planning for these amounts throughout the year can help prevent unexpected adjustments during year-end reporting.

Here are a few common missteps to avoid when you’re managing fringe benefits for your company:

• Don’t take a one-size-fits-all approach to tax treatment. Don’t apply the same tax treatment to every perk or overlook the conditions attached to an exclusion. Instead, take care to meet the requirements for each type of benefit.
• Don’t forget the nuances of tracking company vehicle usage. If your company has corporate cars, be sure to track both business and personal use of company vehicles, and calculate the correct benefits and taxes accordingly.
• Don’t exceed annual exclusion limits. Get familiar with the tax exclusions that are applicable to you, and be sure to avoid going over the annual limits.
• Don’t forget to update your payroll system when things change. When you make changes to a benefit or an employee becomes ineligible for an exclusion, be sure to update your payroll system to reflect the change.

These oversights can lead to inaccurate withholding, unexpected tax liabilities, or corrections to wage reporting. Reviewing benefit policies periodically and coordinating with whoever manages payroll can help catch problems before they accumulate.

Introducing a new employee benefit at your company will involve more than deciding what to offer and how much to spend. You’ll also need to understand how the benefit will affect taxable wages, withholding, and reporting. Reviewing these requirements before offering a new benefit can help prevent payroll errors and unexpected costs.

Before rolling out a new perk, work through these questions:

1. What exactly are we offering? Define what employees will receive and its purpose.
2. Does an IRS exclusion apply? Consult the relevant IRS guidance.
3. Are there eligibility requirements or limits? Review documentation and employee-specific restrictions.
4. Is any portion of the benefit taxable? Use fair market value or a specialized IRS valuation method to calculate it.
5. How should payroll handle it? Establish the correct tax and reporting treatment.
6. What records should we keep? Document your decision and any supporting calculations.

Conducting a review like this will also help you and your team to identify when state tax rules apply or when it may be necessary to seek professional advice. Companies hiring internationally may also need to consider using global payroll software that can support relevant countries' benefits and reporting requirements.

When you understand what fringe benefits in payroll are, you’ll be in a position to make better decisions about compensation and avoid unnecessary payroll corrections. Since a benefit's tax treatment will affect company costs, administrative work, and employee reporting, it's worth evaluating before rollout.

Mercury helps businesses manage banking, spending, and financial operations in one place, giving you more visibility into the finances powering your growing business — and Mercury Payroll lets you pay your team right from the account you already bank with.

^{This article is for informational purposes only and does not constitute legal, tax, investment, or financial advice. Founders should consult their own legal and financial advisors before making important financial decisions.}