Taxation of Employee Compensation

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Federal

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Author: Alice Gilman

Summary

  • Employees' salary and fringe benefits are subject to federal income tax (FIT) and Social Security and Medicare (FICA) taxes. Employers also pay federal unemployment insurance (FUTA) tax on the same amounts. However, while certain cash and noncash fringe benefits may be offered to employees on a tax-free basis, an otherwise tax-free fringe benefit becomes taxable compensation if an employer does not comply with the rules for that particular fringe benefit. See Nontaxable Fringe Benefits; Withholding on Employer-Provided Benefits; Other Common Fringe Benefits With Special Tax Rules.
  • Employees who drive company vehicles on business and who substantiate their business use under the accountable plan rules have a tax-free working condition fringe benefit. Under most circumstances, employees' personal use of company vehicles is subject to FIT and FICA tax withholding and to FUTA tax. See Personal Use of Employer-Provided Vehicles; Withholding on Employer-Provided Benefits.
  • Provided employees substantiate their expenses under the accountable plan rules, employers may reimburse employees tax-free for job related moving expenses, meal and entertainment expenses, educational expenses, equipment allowances, uniforms, outplacement assistance and expenses related to joining exclusive clubs. See Nontaxable Fringe Benefits; Club Membership Rules; Taxability of Other Employer Payments.
  • Although employees' pay and bonuses, including back pay and retroactive wage increases, are always subject to FIT and FICA tax withholding and to FUTA, special payroll tax rules exclude from taxation incentive payments salespersons receive. In addition, employees who receive certain awards and prizes, and employees who receive incentive stock options and options under qualified employee plans, do not receive taxable income when they exercise their options and buy company stock. See Taxability of Other Employer Payments.
  • Special income tax withholding rules apply to taxable fringe benefits. In addition, special annual employee reporting rules apply to many fringe benefits. See Withholding on Employer-Provided Benefits.

State Requirements

The following states have additional requirements for this topic under applicable state law.