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Tax Planning & Preparation

An Overview of Gifts and Taxes

how to handle taxes on gifts to employees

Gifts and taxes can be tricky. Decades ago, the Supreme Court made a landmark decision establishing that a transfer only constitutes a tax-free gift if it is made through “detached and disinterested generosity” or “out of affection, respect, admiration, charity or like impulses.” (Duberstein, 363 U.S. 278, 1960)

In that case, an individual taxpayer gave the names of potential customers to a company that he often did business with. The information turned out to be valuable and the company rewarded the taxpayer with a Cadillac automobile.

The company later deducted the cost as a business expense on its corporate tax return. Meanwhile, the taxpayer did not include the value of the car in his income because he considered it a gift. The Supreme Court ruled that the transfer was not a gift but was a payment for “past services, or an inducement for him to be of further service in the future.”

Educate Employees on Gifts and Taxes

When it comes to gifts and taxes, explain to employees the tax implications clearly so that there are no unpleasant surprises.

Most of the time, it’s easy to explain that perks, such as a bonus or the use of a company car, are treated as income and subject to taxes.

Stock options are more complicated to explain. As this incentive moves down to lower employee ranks, it reaches younger or less financially knowledgeable employees who are generally least able to afford the taxes and most likely to misunderstand how to exercise options advantageously.

Rather than viewing options as a long-term incentive to stay with a company, many employees believe options have immediate cash value that goes up over time.

Some employees are stunned when they exercise their options at and incur a large tax bill. Other employees who exercise at the wrong time or during a down market may owe more in taxes than they made on the stock.

A staff member faced with an unanticipated tax bill may blame the company. If your company offers stock options or other valuable benefits as incentives, don’t let them backfire through misunderstanding.

A few tips:

  1. Offer education classes shortly after hiring.
  2. Explain the implications of benefits upfront so employees are clearly informed about their risks and rewards.
  3. Inform employees when fringe benefits are tax-free. For example, the cost of up to $50,000 of group-term life insurance coverage provided by an employer is not included in income.

Employee achievement awards can also present some complex tax consequences. In some cases, the value of employee achievement awards can be excluded from taxable income but there are strict rules that must be followed.

Some Basics on Gifts and Taxes

The award must be an item of “tangible personal property” and not involve cash, a gift certificate, or other cash-equivalent item. It must also be given for length-of-service or safety achievement.

The amount that the employee can receive tax free under this exception is limited to the employer’s cost and cannot exceed $1,600 ($400 for awards that are not qualified plan awards) for all awards the employee receives during the year.

In addition, the employer must make the award as part of a meaningful presentation. The tax-free employee achievement award exception does NOT apply if:

  • The length-of-service award is for less than five years of service or if the employee received another length-of-service award during the year or the previous four years.
  • The safety achievement award is given to a manager, administrator, clerical employee, or other professional employee.
  • More than 10 percent of eligible employees previously received safety achievement awards during the year.

Gifts to vendors, suppliers or customers also can present complicated situations with many strings attached. The basic premise on these types of gifts is that the business can deduct gifts of as much as $25 per person per year.

This includes both direct and indirect gifts. For instance, if you give a gift to a customer’s spouse or child, it is considered to be an indirect gift to the customer. If you give gifts to a select group of a company, the gifts are treated as being made to the individuals within that group.

The annual limit per person is relatively low, but at least you don’t have to count incidental costs or gifts of a minimal value such as coffee mugs. Special rules apply to tickets that may qualify as business entertainment.

Practical Advice

Consult with your tax adviser and coordinate gift-giving activities with your payroll department when they involve employees. Make sure that gifts reflect the strict letter of the tax law.

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