Many small businesses treat their employees like family (for many, that’s because they are indeed family!) So, sometimes the owners forget to withhold income taxes on compensation that the IRS deems taxable. Since taxes were not withheld, many employees would inadvertently under-report their income (it is the responsibility of the employers to withhold taxes and properly classify compensation). In case of an audit, these employers could face a great deal of trouble because of the alleged tax evasion resulting in fines and jail time in the worst case scenario.
Here are 4 scenarios where we discuss common items that the IRS deems taxable and where income tax should be withheld. Let’s take the example of “Joe”, a fictional business owner who runs a business with the help of his family.
1. BONUSES: Joe promised his son Junior that if he were to do a great job, Joe would give him a $1,000 bonus outside of his regular payroll. Because Junior did a great job, Joe decided to give Junior $1,000 cash as a bonus at yearend plus a pat on the back. Well, while the pat on the back may be tax-free, the bonus wasn’t. Joe overlooked that this bonus was actually part of compensation and required income tax withholding as well. So, if the bonus were $1,000, Joe should have handed Junior a check for the net amount after withholding taxes for Uncle Sam. The amount withheld, of course, could vary from person to person.
What if Junior complained and said that he was promised a $1,000 bonus and he would not settle for anything less? Well, if Joe was to agree with Junior’s argument and did indeed give Junior $1,000, Joe would still need to set aside a portion for Uncle Sam. Joe would need to gross up (increase) the bonus reported as compensation to an amount that after the taxes were withheld, would still net to $1,000.
2. GIFT CARDS AND GIFT CERTIFICATES: In order to boost morale, Joe decided to give each employee a $100 gift card. Now, since it was a gift card and not cash, Joe thought that wouldn’t be taxable. Well, Joe was wrong! Per IRS regulations (as clarified by Publication 525), a gift card is essentially “cash” issued by a store and giving employees gift card would not be different than giving the person cash. Therefore, this would be treated as a bonus and just like the scenario above; it would need to be reported as income on the W-2 and have proper tax withholding applied.
3. DEBT FORGIVENESS: Joe’s brother “Tom” worked for Joe while looking for another job. In the meantime, Tom also borrowed $1,000 from company. When Tom decided to move on, Joe forgave the loan. That amount forgiven should actually be considered as compensation per Section 7872 of the Internal Service Code (Title 26). And just like scenario #1 above; it would need to be reported as income on the W-2.
4. NON DE MINIMIS FRINGE BENEFITS: Joe likes to take everyone out every weekend to a happy hour. Of course he would talk about the business but the overall purpose would be to have fun. Joe thought that this was just a “team building event” and that these expenses ought to be “de minimis”. Well Joe is wrong again! For a fringe benefit to be “de minimis” (i.e. to be excluded from compensation) it has to be occasional and insignificant per Publication 15-B. Having regular happy hours with beer tabs picked up by the company is simply not de minimis. So, Joe should stop picking up tabs for everyone unless he is willing to pay for them out of his own (and not the company’s) pocket!
There are many other transactions that could be categorized as income by the IRS that many business owners overlook (ranging from severance pay to zero interest loans to free company cell phones, to gym memberships paid by the company…). Hence, please discuss the tax impact of fringe benefits with your accountant if you don’t want to break the law!
Contributed by Sam W.