Bookkeeping – Employee Benefits (Lesson 88)
There are a multitude of employee benefits employers provide to their employees. This series covers several groups of benefits and explains the legal and accounting issues related to them. This particular lesson introduces the concepts behind employee benefits and the basic accounting process. In addition, I’ll explain the tax consequences and the corresponding payroll process involved. The following is a list of the lessons involved with employee benefits as links to the particular subject matter.
* Employer Health Insurance Mandate – Lesson 89
* Employer Provided Retirement Plans – Lesson 90
* Health Savings, Reimbursement and Flexible Spending Accounts – Lesson 91
* Cafeteria Plans – Lesson 92
* Other Employer Provided Benefits – Lesson 93
Providing benefits to employees is advantageous to the employer. All for-profit business have the same three goals:
1) Earn a profit;
2) Provide for the long-term security of employees; and
3) Provide a product or render a service desired by customers.
Benefits are a necessary function of goal number two.
All employee benefits are founded in the Internal Revenue Code. The legal implications are set by Congress and regulated by the Internal Revenue Service. The primary concept is whether the benefit is inclusive in earned income or is excluded. To understand this, let’s first explore the legal issues.
Legal Compliance of Employee Benefits
The tax code is the hub of regulations identifying employee deductible benefits. The code sets the law in regards to inclusion or exclusion of the value of the benefit in the employee’s gross income for tax purposes. This is important to understand, inclusion of the value of the benefit in his/her gross income obligates the employee to not only income taxes but to Federal Insurance Contributions Act (FICA) payments consisting of two components, 1) Old-Age, Survivors, and Disability Insurance (OASDI) commonly referred to as Social Security and 2) Hospital Insurance (HI) known as Medicare. Their rates are 6.2% and 1.45% respectively. In addition, if the benefit is included in the employee’s gross wages, it must also have the FICA taxes matched by the employer. To make it more expensive, if the value is included in the employee’s wages, this means this value is subject to both Federal Unemployment Tax (FUTA) and State Unemployment Tax. One final insult to injury, the employer must also pay worker’s compensation insurance on this value too. In the aggregate, if a benefit is included in an employee’s wages, the additional cost will run no less than 15.3% and on average over 20% of the value of the benefit.
It behooves an employer to offer benefits that comply with the tax code to exempt (exclude) the value from the employee’s gross income.
To exclude the value of the benefit from the employee’s gross income, the benefit must generally pass two sets of standards. The benefit must be a ‘qualified’ benefit and it must be ‘nondiscriminatory’ in its application. The following subsections explain these two standards in more detail.
Congress advocates social norms by enacting laws to force (mandatory) or coerce (voluntary via tax credits or penalties) employers to provide certain benefits. For example, the employer health insurance mandate, commonly called Obamacare, requires all large employers (50 or more full-time employees) to provide health insurance coverage. To comply with the law, the employer’s provided plan must pass several tests. Compliance with the tests makes the plan ‘qualified’ and therefore meeting the first of two standards.
This same principle is used with all benefits provided to employees. The benefit must be ‘qualified’, i.e. in compliance with the code to receive the status of excludable from an employee’s gross income. However, the benefit must also be nondiscriminatory.
When the term is used the common person thinks of civil rights. In regards to the employer/employee relationship and financial compensation discrimination refers to two distinct types of employees:
1) Highly Compensated Employees – Highly compensated employees are generally referred to as the upper management of a business. Often employers desire to retain and reward these employees by providing better benefits to the detriment of all others. Congress believes that this separation of two groups creates social harm and therefore penalizes employers that provide different plans to the two groups. In general, highly compensated employees include:
A) Any one of the five highest paid employees;
B) Highest paid 25% of all employees; OR
C) A shareholder (owner) having more than a 10 percent interest in the company’s equity.
2) All other employees
To alleviate discrimination Congress defines nondiscrimination in regards to the various benefits provided. This means the terms (rules) for discrimination are different with the various benefits available. As an example, the nondiscrimination rules for retirement plans are different from the rules for life insurance.
Legal compliance is customarily the job of the human resources officer and not the accountant. However, the accountant is responsible for the financial compliance and tax reporting of the respective benefits. It is always a good idea for the two to meet regularly to make sure compliance exists and that information conveyed to the employees matches the actual financial (paycheck and reports) outcomes.
One last note to legal compliance, often third parties offer fully qualified plans as a package for employers. This means that their plans have received a determination letter from the IRS approving the plan for use. Small businesses implementing benefits should seek out these approved plans for use as the cost to design and comply with the law for a customized in-house plan is cost prohibitive.
Basic Accounting Principles for Employee Issues
All benefits fall into one of three groups of payment. The most common is a function of the employee’s actual paycheck. This is standard for when an employee participates in the payment of the benefit. A perfect example is a deduction for a contribution to a retirement plan. The second group of payments consist of direct payments by the employer for the employee either as a function of the employer providing the benefit at no cost to the employee or as a co-share with the employee. The third group of payments reflect pure prepayments made by the employer for the employee. In this case, the employee owes the money back to the employer similar to a receivable from a customer.
The following three sub-sections cover the accounting process in more detail for each respective form of payment.
In a direct deduction the employee is requesting the employer to deduct a portion of his compensation for the respective benefit provided by the employer. During payroll processing the amount withheld becomes a liability for the employer. Think of the economic transaction as a full net payment to the employee and then the employee hands back to the employer some cash to pay the amount for the respective benefit. The net result is additional cash in the employer’s bank account and an accrued liability for the amount owed to the third-party benefit provider. The value is customarily held in accrued payroll – employee benefits. Typically the amount is coded to the third-party benefit provider.
As with all control accounts, use a spreadsheet to reconcile the amounts owed to third-party providers of benefits and the respective sub-amounts paid by employees. This accrued expense account will typically have the following third-party benefit providers as control identifiers:
* Health Insurance * Retirement Plan
* Dental Insurance * Dependent Care
* Vision Care * Health Savings
* Life Insurance * Thrift/Annuity Provider
* Disability/Long-Term Care Insurance
I suggest using one spreadsheet with a summary tab and a tab for each third-party benefit program. On the program tab, have one section for each month of the fiscal year so that the entire year is kept together.
Another form of direct deduction is when the benefit is a qualified and nondiscriminatory pre-tax deduction. This type of benefit is not taxable for FICA (see above) or income taxes. Therefore the employee saves both forms of taxes. Furthermore, the employer saves on matching taxes along with FUTA, SUTA and worker’s compensation insurance.
Similar to a deduction from the net pay, this type of benefit is a direct deduction from gross pay before determining wages to calculate payroll taxes. Here is an example:
Fiber Optics has a fully qualified dental insurance benefit as a pre-tax deduction for the employees. The employee must pay $18.00 per payroll period for the family plan. Jason, an employee with Fiber Optics, is paid $700 gross pay per week and elects to join the plan. The following is Jason’s paycheck report:
Gross Wages $700.00
Dental Program 18.00
Taxable Wages 682.00
Federal Withholding 79.40
FICA (@7.65%) 52.17
State Withholding 41.15
Net Check $509.28
Notice with Jason’s check, the benefit is deducted from gross wages first then the taxes are calculated. With accounting, a direct deduction is always stated in a qualified way; it is either:
A) Direct deduction from gross wages, or
B) Direct deduction from net wages.
If directly deducted from net wages, i.e. a post-tax benefit (unqualified), Jason’s paycheck report would look like this:
Gross Wages $700.00
Federal Withholding 81.77
State Withholding 41.78
Dental Insurance 18.00
Net Paycheck $504.90
The pre-tax method saves Jason $4.38. This may not seem like a lot, but now multiply it by 52 weeks, it becomes $227.76. Just as with the net paycheck deduction, the pre-tax deduction is a credit to accrued payroll – employee benefits instead of a credit to cash.
Direct Payment by the Employer
Many of the benefits provided are 100% paid by the employer or are co-shared between the employer and employee. If the payment is 100% paid by the employer then the entry is simple, debit the respective expense such as employee benefits (sub-account of labor in cost of sales) and a credit to cash. When accruing the bill, debit expense and credit accrued payroll – employee benefits which is my personal preference. The employee’s share is accounted for in a similar manner as the direct deduction payment illustrated above.
Pre-Payments Made by the Employer
Some benefits require the employer to prepay well in advance of the actual benefits utilization. A perfect example are premiums for disability or life insurance. Whether the benefit is qualified or not is irrelevant as a prepaid expense is recorded by debiting a current asset account and crediting cash. When the expense is actually accrued, the debit value in the prepaid account is simply transferred to the respective payroll benefits account (cost of sales) when the payroll is run.
Effectively, instead of cash being credited, the prepaid expense is credited. Notice how this simply bypasses the current liabilities account for accrued payroll – employee benefits. There are some exceptions to this process. For example, it is not uncommon for an employer to loan money to an employee. This is not a prepaid expense but a current asset employee receivable located beneath customer receivables in the trial balance.
As illustrated above, qualified nondiscriminatory benefits are not taxable for federal income purposes or for FICA taxes. For the employer this is significant as it also reduces the employer’s obligation for:
1) Matching FICA taxes
2) Unemployment taxes (FUTA/SUTA)|
3) Worker’s compensation insurance premiums
The real key is the deductibility of the benefit’s cost for tax purposes. Some benefits are just not deductible because they are either illegal or specifically not allowed as a normal expense for business purposes. This is commonly found with expenses incurred that directly benefit owners and highly compensated or key employees. Examples include:
* Auto expenses for personal use of a company vehicle – this is the most common benefit provided to owners and key employees. The total cost to operate the vehicle is suppose to be allocated between actual business use and personal use based on the ratio of miles driven for these two elements (business & personal). This is explained in detail in a lesson in the tax adjustments section of Advanced Skills.
* Travel expenses – owners are notorious for wanting to deduct extravagant (luxury) costs for travel purposes. This includes staying at high class hotels, eating at fine restaurants and buying unwarranted entertainment. Often the actual marginal cost of this travel exceeds the tax savings, if any, allowed. The IRS scrutinizes and disallows luxury trips even if the entire trip has a legitimate business purpose.
* Cell phones – personal use of a cell phone tied to the business is not deductible for tax purposes.
* Social club dues
* Meals and entertainment – in general, 50% of all meals and entertainment expenditures are nondeductible for tax purposes. Owners often try an end around by claiming every meal as deductible because business was discussed at the meal. The IRS uses the standard of ordinary in order to allow even 50% of the cost of the meal as a deduction. To pass this test, the meal must be a customer/company prearranged meeting and designed for the convenience of the customer.
In general, the above benefits may be paid by the business but is adjusted at year-end in the GAAP to tax adjustments trial balance when preparing the business tax return. Also notice these benefits inure to the owners/officers and not for the general working staff. In effect, they are discriminatory in nature, thus not legally deductible for tax purposes.
Summary – Employee Benefits
Employee benefits are an excellent tool to retain and inspire good employees. To qualify as a tax preference benefit, the employer must make sure the benefit passes the legal compliance tests as regulated by the Internal Revenue Service. The benefit must be a qualified benefit and pass the nondiscrimination tests. If it meets both standards then the benefit is deductible for tax purposes and can decrease the overall cost to the employee for his share of both FICA and income taxes. In addition, by excluding the value of the benefit from the employee’s wages, the employer doesn’t have to pay payroll taxes for the value for the benefit.
For those benefits not meeting the standards, the amount is deductible as an expense if either the benefit is normal and customary or the value of the benefit is included as earned wages for the employee. Some benefits are purely employee directed and paid by employees. These costs are either A) recorded as a current liability for amounts withheld from the employee and owed to third party providers or B) prepaid by the employer and owed to the employer by the employees paid via net paycheck deductions.
The accounting process is similar to typical expenditures whereby the value of the benefit borne by the employer is recorded to benefits as a sub-account of labor in cost of sales. The credits are either cash or recorded to accrued payroll – benefits in the current liabilities section of the balance sheet. Any employee paid portions are directly credited to accrued payroll – benefits or to cash depending on the nature of the transaction.
Lessons 89 – 93 will go into more detail related to each type of benefit and how to handle the respective accounting. ACT ON KNOWLEDGE.
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