The Importance of Distinguishing the Taxable from the Non-Taxable
Payroll preparation is a complex process, and the matter of determining which of the payroll deductions are taxable can be quite confusing. However, one should have a clear understanding of payroll deductions in order to distinguish the taxable from the non-taxable.
Payroll deductions are dollar values taken from the gross salary of an employee; they can be either mandatory or voluntary. Those that are mandatory pertain to federal and statutory taxes, the values of which would depend on the amount of gross salary used as the basis for tax computations.
Voluntary deductions, on the other hand, pertain to the items listed in the Payroll Deductions Authorization form submitted by the employee. This particular aspect may seem easy at first but certain conditions could give rise to the complexity of determining which of the voluntary payroll deductions are taxable.
Some of these authorized reductions should be taken out of the employee’s gross salary first, before the tax rates are applied and before they are subtracted from the individual's wages. The IRS calls this the “pretax deduction” in which the resulting effect becomes a tax credit in favor of the employee.
In view of this, the explanations in this article have been organized according to the circumstances that render the payroll deductions taxable. That way, we can avoid creating a tax credit where it is not due. It should be best kept in mind that these types of salary reductions should be taken out of the employee’s wages after the tax calculation or post tax deductions.
However, before delving into the matter, there is also the matter of determining which of the payroll deductions are considered lawful.
Payroll Deductions Considered Legal
Some employers have the notion that voluntary payroll deductions are arbitrary and are lawful for as long as they are stated in the payroll authorization forms submitted by their employees. Labor laws have certain provisions for considering the legality of payroll subtractions aside from those mandated as federal and statutory withholding taxes. Other lawful deductions include:
- Deductions that were ordered by courts by way of orders of garnishment.
- Deductions for plans for health, pension, or welfare contributions not considered as fringe benefits but not as a result of downgrading the employee's salary.
- Deductions to cover health, pension, or welfare contributions as part of a collective bargaining agreement entered into by the employer and the union to which the employee belongs.
After determining which items are considered legal to withhold, we are now ready to discern the taxable payroll deductions.
Personal Expenses Taken from the Employee’s Wages as Taxable Payroll Deductions
Certain personal services or privileges are granted to an individual only because the employee is a regular wage earner and can authorize his employer to extract the payments from his wages.
These personal expenses are considered taxable because they will be directly taken out of the employee’s gross earnings.
- Cash advances against salaries.
- Short-term loans against salaries granted by the employer.
- Costs of insurance intended as protection against losses from fire, theft, or personal travel or accidental death that were billed against the employer's account.
- Life insurance coverage for the employee’s spouse and/ or dependents paid separately from out of the employee's salaries. The de minimis rule of less than $2,000 as a non-taxable deduction applies, if the spouse’s and / or the dependent’s insurance coverage was incorporated in the employee’s tax-free insurance benefit. The deduction which resulted from the additional cost of the benefit is taxable if the excess amount is more than $2,000.
- Costs of long-term insurance that provide economic value that were also charged against the employer's account.
- The value of meals during the employee’s off-hours billed against the employer's account.
- Meals that form part of lodging expenses, previously discussed as not included among the employee’s wage benefits, because the lodging accommodation is for the employee’s convenience and not the employer’s.
- Deductions as payment for the company shares of stock bought by the employee under a non-qualified employee stock purchase plan.
- Salary deductions representing installment payments for goods or real estate property bought by an employee from his employer’s business.
- Employee's personal telephone charges included in the company's billing statement.
Please proceed to the next page for information about taxable payroll deductions, including "Voluntary Deductions Resulting from Expenses that Exceed the Allowable Fringe Benefit Limits"
Voluntary Deductions: Expenses that Exceed Allowable Fringe Benefit Limits
Certain fringe benefits are allowed as non-taxable up to a certain limit. However, there can be instances where the costs of the services provided would exceed the maximum allowed as non-taxable privilege.
In such cases, the additional costs become taxable payroll deductions against the salary of the employee. Hence they should be treated as post-tax deductions or taken out of the employee’s salary after the tax has been computed and subtracted.
However, it is important that the additional costs be stated in the payroll deduction authorization form if the employee wishes to continue the services once the costs exceed the allowable limit of non-taxable fringe benefits. The following are examples of these types of salary reductions, but are not limited to:
- Costs of dependent care assistance provided by the employer that are non-taxable up to $5,000 if a married employee files a joint return with his or her spouse. It becomes $2,500 per employee if their tax returns are filed separately. Succeeding dependent care costs in excess of the $5,000 maximum become taxable salary reductions.
- The cost of group-term life insurance with more than $50,000 worth of coverage, but reduced by the amount allowed as non-taxable costs. The difference then becomes the amount chargeable against the employee’s wages and subject to tax. To determine the cost included in taxable payroll deductions, a detailed guide is provided in IRS Publication 525 under Worksheet 1- Figuring the Cost of Group-Term Life Insurance to Include in Income.
- An educational assistance program provided by the employer is non-taxable up to $5,250. Education costs paid for by the employer that exceed the $5,250 maximum can be taken from the salary of the employee as a taxable payroll deduction.
- Contributions made by an employee to the flexible spending plan like cafeteria plans are considered part of the employee’s taxable wages; hence dollar values taken from the employee’s salary to pay for such contributions are also considered as taxable.
Payroll Deductions for Employees Not Qualified for Tax Exemptions
S corporation employees who own at least 2% of the shareholdings and highly compensated employees of the company do not qualify for tax exemptions extended to regular employees. In such cases, payroll deductions are taxable for payments or contributions made by these types of employees for the following, but are not limited to:
(1) Accident and health benefits for spouses and dependents billed against the employer's account.
(2) Dependent care assistance if availed and not provided as part of the employee's compensation package.
(3) Lodging expenses if furnished for the convenience of the highly compensated employee and not provided as part of the compensation package.
(4) Moving expenses if incurred for the convenience of the highly compensated employee.
What is a highly compensated employee?
The highly compensated employee includes (1) one among the five highest-salaried executives or officers of the company, or (2) those who own more than 10% of the company’s shareholdings, and in some cases (3) those who belong to the top 25% of the company’s highest-paid employees excluded from the plans cited above.
As a recap, we reiterate that the objective in determining which payroll deductions are considered taxable is to ensure that the dollar values of these reductions shall still be treated as taxable wages. Taking them out after the computation of applicable tax rates on the gross salaries earned eliminates the creation of unwarranted tax credits.
Reference Materials and Image Credit Section:
- IRS Publication 525 – Main content — https://www.irs.gov/publications/p525/ar02.html
- Holding-Back or Deducting an Employee's Pay — https://www.worldlawdirect.com/article/1962/holding-back-deducting-employees-pay.html
- Leave And Earnings Statement
- Regulatory risk bow tie – deter-detect-deal with – generic tax obligations example