Article by James P. Sweeney, RSM US LLP
With perks that may range from free lunches in the dining hall to deeply discounted tuition fees, independent schools’ generous fringe benefits packages serve as key competitive advantages in helping them recruit and retain high-quality faculty and staff. Different fringes affect staff at all levels; some are intended to defray living expenses for modestly compensated teachers, while others may serve little purpose beyond attracting a superstar head of school in an intensely limited field.
As important as they are to a school’s overall compensation package, fringe benefits are often something of a gray area—and a potentially fraught one—when it comes to taxability. Neither the Internal Revenue Code (IRC) nor Treasury regulations define fringe benefits in definite terms, yet employers are required to include certain fringes in an employee’s gross income in the year in which he or she receives them. Schools that fail to administer fringe benefits properly, or to clearly convey potential tax implications to employees, risk subjecting themselves and their employees to unwelcome scrutiny, greater tax liability and, in some cases, IRS penalties.
Here’s a look at the potential taxability of several types of fringe benefits that are common to independent schools, along with guidelines to help business officers play within the many rules impacting them. With tax season approaching, a careful review should be an important element of your school’s strategy for offering a package of fringe benefits that is at once competitive, financially sustainable and in compliance with the law.
Tuition Reduction Benefits
- May be exempt from income tax withholding
- See IRC Section 117
Tuition breaks for the children of employees vary widely among independent schools, from a relatively small percentage discount to full tuition waivers, though the latter are becoming rare. Overall, the benefit is one of the most valued a school can offer (particularly when many employees are parents of young children), as well as one of the easiest to provide. Schools may provide this benefit in the form of a financial break or a cash grant, and may account for it as compensation, a benefit or financial aid, depending on the circumstances.
To be a qualified tuition reduction program (QTR) under Section 117, it must not discriminate in favor of highly compensated employees (see sidebar). In addition, as explained by Debra Wilson, legal counsel at NAIS:
A QTR may be used to benefit a child who is a son or daughter, stepson or stepdaughter, any legally adopted child, or a foster child who is a member of the employee’s household and whose principal place of residence is the employee’s home. This child must also be a dependent—that is, the child must fall into one of the following categories: (1) the employee provides over one-half of the child’s support for the year; (2) both of the child’s parents are deceased and the child is less than 25 years old; (3) the child’s parents are divorced or separated and the child receives one-half of his or her support from either or both parents; or (4) the employee is allowed to treat the child as a tax dependent under special rules that apply to multiple support orders.
Source: Tuition Remission—a Tax Free Fringe Benefit, 2011
Working Condition Fringe Benefits
- May be exempt from income tax withholding
- See IRC Section 132
Working condition fringe benefits are defined as including any property or service provided to the extent that, if the employee had paid for it, she or he would have been able to deduct the cost as an “ordinary and necessary business expense” on her or his individual income tax return. A benefit must be properly substantiated and documented to receive the benefit exclusion. Within independent schools, common examples might include work-related club memberships, automobiles, travel, computers, professional dues, publications and events related to the individual’s work for the school—for instance, a ticket to a lacrosse tournament for an athletic director who is required to attend for recruitment purposes.
Many independent schools provide a vehicle to the head of school and other employees. In such cases, employees must maintain a written log of mileage and the business purpose for the trip. Because this record-keeping can be onerous, it’s not uncommon for schools to provide a (taxable) car allowance instead.
The following are considered employees for the purpose of working condition fringe benefits:
- Current staff and faculty
- Business partners
- Trustees/directors
- Independent contractors
- Volunteers
Taxable fringe benefits for employees should be reported on Forms W-2 and W-3. Taxable fringe benefits for independent contractors should be reported on Form 1099.
Cash payments or cash equivalents are not working condition fringe benefits, unless they represent reimbursements paid under an accountable plan.
De Minimis Fringe Benefits
- May be exempt from income tax withholding
- See IRC Section 132
De minimis fringe benefits include any employer-provided property or service with such a minimal value that accounting for it could be considered unreasonable or administratively impractical. The benefit’s value is determined by the frequency at which it is provided to any individual employee, or, if this is not administratively practical, by the frequency at which it is provided to all employees as a whole.
Common de minimis benefits at independent schools might include cafeteria or dining room meals and snacks, as well as tickets to school-sponsored theater or sporting events. Section 1.132-6(e)(1) also provides examples that include occasional and not routine group meals, employee picnics, traditional birthday or holiday gifts (not cash) with a low fair market value, and commuting use of a school-owned vehicle if no more than once per month.
For cafeteria/dining room meals to meet the exclusion, the facility must be on or near the school, its revenue must normally equal or exceed direct operating costs on an annual basis, and meals furnished must be provided during, or immediately before or after, the employee’s workday.
If a benefit does not qualify as a de minimis fringe benefit, the entire benefit is taxable, not just the portion that exceeds the de minimis limits.
No-Additional-Cost Benefits
- May be exempt from income tax withholding
- See IRC Section 132
No-additional-cost benefits are defined as services or products that the employer provides to employees (whether for free or at a discount) without incurring a substantial additional cost, such as labor expenses or foregone revenue. The service must be offered in the ordinary course of the employer’s line of business; for instance, a service that the school already provides to students.
No-additional-cost services occur frequently in industries with excess capacity services, including transportation tickets, hotel rooms and entertainment facilities. In the context of independent schools, they might include internet access, use of athletic and recreational facilities, and tickets to athletic or entertainment events that would occur regardless of attendance and that would not represent any revenue loss to the school.
Qualified Employee Discounts
- May be exempt from income tax withholding
- See IRC Section 132
Many schools sell goods or services to employees at a lower price than they charge others. Examples include tickets to sporting and entertainment events, along with spirit wear and other merchandise from the school bookstore. For tickets and other services, the discount is excludable if it is no more than 20 percent of the price charged to the general public. For merchandise or other property, generally the excludable discount is limited to the employer’s gross profit percentage times the price charged to the public. For instance, if a bookstore has a 50 percent gross profit percentage, the employee discount must not exceed 50 percent of the usual sale price.
Section 457 Deferred Compensation Plans
- Tax deferrable
- See IRC Section 457
In a Section 457 plan, an employer essentially defers an unlimited amount of compensation into the plan on a pre-tax basis. Typically offered to attract and retain certain highly compensated employees with supplemental retirement benefits, 457 plans are sometimes called “golden handcuffs” in that they stipulate that employees meet certain periods of service to receive the deferred compensation.
Besides providing supplemental compensation, a 457 lets executives both reduce their taxable income and receive distributions after retirement, when they are likely to be in a lower tax bracket.
A 457 operates similarly to the 403(b) plan many schools offer, with some distinctions:
- Assets are owned by the institution rather than the individual. They are subject to the claims of its creditors and other risks, and invested as determined by the institution and the leader.
- A 457 is relatively less difficult to establish because there are no requirements regarding coverage, eligibility, participation, vesting, etc. It can be designed in a variety of ways, depending on the employee’s time to retirement, desired tax strategy and funding arrangement, and other features preferred by the institution and employee.
- There is no penalty for withdrawal before the age of 59 (although the withdrawal is subject to ordinary income tax).
- Rollovers in and out are not permitted.
- Loans are not permitted.
- Independent contractors can participate.
There are many complexities involving 457 plans, but some additional details follow.
Section 457: Funding
Section 457(f) plans must be unfunded. The institution owns the plan assets until distributed to employees. However, they can be “informally funded” through the use of institutionally owned annuity contracts, life insurance policies and other types of investments.
If funded with a life insurance policy, the policy is purchased by a benefits trust (usually a “rabbi trust,” which protects against most adverse contingencies, except claims of the institution’s creditors). The trust uses the contributions to pay the premiums on the life insurance policy. Use of a rabbi trust also provides plan participants with some security without violating the substantial risk of forfeiture requirement in order to defer taxation into the future when payable.
Amounts of funding also can vary among plan participants. For instance, if four individuals are participating, each will have varying levels (time) of service to the school. One approach for a school may be to defer a monthly amount based on years of service. For example: set asides in the amount of $3,000 per month for service greater than 20 years, $2,000 for service of 15 to 20 years, and $1,000 for service of 10 to 15 years, all based on the date the plan is put into place.
Section 457: Eligibility
Employer: Any 501(c) tax-exempt organization, as well as state and local governments and their agencies, as permitted by applicable law.
Employee: In private institutions, limited to a “top hat” group (select group of management or highly compensated employees). In public institutions, any group or single employee may participate.
Section 457: Vesting
457 plans can have a vesting schedule or be 100 percent vested immediately. The general practice is that when taxation occurs, the participant receives the plan balance. A school may make various provisions, e.g., giving participants an immediate right to benefits when substantial risk of forfeiture lapses. Or, if the participant terminates employment or becomes disabled, the benefits can either be both vested and paid, or the plan can continue in place until the specified distribution dates.
Section 457: Distributions
The employee elects the distribution dates for payment of benefits. Distributions can be made at any time but are usually coordinated with the date when the substantial risk of forfeiture lapses. Payment is generally made in a lump sum.
If funded with a life insurance policy, the institution may use the policy’s cash value to pay the retirement benefits.
Section 457: Taxation
Accumulations are immediately and fully taxable to the employee when substantial risk of forfeiture lapses, regardless of whether or not the employee receives them. Distributions are taxed as wages, and withholding reporting is via a W-2.
If the plan is funded with a life insurance policy, the employee pays the income tax due on the premium amounts. However, the institution may also elect a “double bonus” arrangement, in which the executive is paid a bonus for the amount of income tax due.
Section 457: IRS Form 5500 Filing
Schools must file a one-time, one-page notice of plan adoption with the Department of Labor to document the plan’s “top hat” exemption from ERISA. Public institutions are not subject to any Form 5500 filing requirements.
