Employee benefits are subject to a wide range of tax laws. There are almost as many different perks available to employees as there are special tax considerations affecting them. For both employers and employees, navigating this ocean of compensation, income taxes, and liability takes a lot of insight and assistance. For accountants and attorneys alike, the taxation of benefits programs is a rich area of study and specialization.
Both income taxes and the growth of non-wage benefits developed partially in response to one another, as well as resulting from macroeconomic changes across the American labor force and market. The relationship between worker benefits to the tax code has changed and fluctuated constantly over the 20th century.
Income Taxes and Non-Wage Compensation
A popular rumor holds that non-wage employee benefits arose in response to rationing during World War II. The story suggests that, unable to raise salaries in order to attract or retain talent, employers instead devised a variety of benefit programs, ranging from healthcare sponsorship to defined contribution plans.
While there is some truth to the idea that wartime economics led to a growth in the popularity of benefits programs, their existence predates World War II by generations. In fact, non-wage benefits plans arguably predate income tax itself in the United States . While Congress made several attempts at levying a national tax on income throughout the later half of the 19th century, income tax as we know it today didn’t take shape until the 16th Amendment was ratified in 1913 .
Meanwhile, one of the earliest defined benefits plans offered was an employee pension program developed by the American Express railroad company in 1875 . Until the Industrial Revolution, the overwhelming majority of labor in the country was concentrated in agriculture, and even then largely in smaller-scale family farms. The shift to manufacturing and machine-augmented labor created a sudden influx of workers seeking wages, job security, and the same predictability of income that had historically been provided by the seasonal ebb and flow of farming. As a result, major employers like railroad companies needed a way to create the appearance of job security to attract workers, and to incentivize retention .
Along with disrupting the agrarian foundations of the U.S. economy, the Industrial Revolution was having a dramatic impact on life expectancy and the availability of modern medicine. This meant that employers needed a way to manage an aging workforce, while workers sought some form of insurance against aging past their prime working years, without a family farm to generate income .
The American Express pension promised a payout to workers as a percentage of their working salaries, contingent on a few strict qualifications which tended to be standard among other benefits plans at that time. Depending on the employer, qualifying workers must have 10-20 years of service with the company, and must be aged 60 years or older. Even then, payouts could be limited to 35 percent of the employee’s working pay. Through these kinds of qualification mechanisms, employers could advertise benefits plans to entice workers, but faced very limited risk of having to actually pay out .
While these sorts of programs quickly gained popularity and adoption among many of the larger early industrial employers of the late 1800s (banks, factories, public utility companies, manufacturers), they didn’t achieve truly widespread use until the 1920s . This trend took hold in the wake of the ratification of the 16th Amendment, establishing laws for federal taxation of income. Although this laid the groundwork for the modern tax code, the system has faced numerous reforms and amendments itself . One early amendment made to the code was to officially exempt pension plans, enabling employer contributions to be deducted and thus creating a new incentive to both offer and sustain employee pensions. Up until this point, non-wage benefits occupied a position of some ambiguity with respect to income taxes .
Along with cementing the tax-privileged status of qualifying retirement and pension plans, this laid the foundation for labor unions and their negotiations with employers. Benefits, wages, and worker rights all became intertwined in the labor landscape of the United States for decades to come .
World War II and the Mid-Century Transition
Retirement plans were the dominant employee benefits in the early 20th century right up until World War II broke out. The U.S. government, still in recovery from the Great Depression and wary of the inflationary experiences of Germany during the first World War, was anxious to control wages and prices in an effort to curb further inflation at home . While this was not the impetus for widespread adoption of employee benefits as a whole, it was the driving force that led to employer-sponsored health insurance .
From the turn of the century into the 1930s, private individual health plans were the norm, where health insurance was utilized at all. The disruption to labor markets, along with rationing, price controls, and other macroeconomic initiatives implemented in response to the Depression or as part of the war effort, created a void in employer resources to attract and retain workers. Once again, they responded by formulating a new non-wage benefit aimed at supporting families and fostering a sense of security among workers .
At the same time, the federal controls on wages was leading to significant angst and frustration among the labor market, and the threat of widespread strikes and other forms of labor protest became a serious threat to the economy and war effort. In response, the War Labor Board implemented a new income tax exemption to employers sponsoring employee health plans. This made employer contributions deductible on federal returns, while the benefits were entirely tax-free, to the employees .
What started as a measure to avert crisis and labor strikes ended up becoming an expectation. As more and more employers leveraged these tax-benefitted health plans, American workers grew accustomed to getting their health insurance through work, rather than as individuals. The end of the war and the return home of American GIs exposed more workers to the new system, reinforcing its popularity and utilization . By the 1960s, employer-sponsored health insurance plans had overwhelmingly displaced the formal individual market, a status that has persisted right into the start of the 21st century and provided a central tenant of the Affordable Care Act of 2008 .
Contemporary Trends in Taxation and Benefits
Among the most significant legal changes to employee benefits and their taxation in the U.S. was the Employee Retirement and Income Security Act .
Despite their popularity with workers and employers, retirement plans and pensions were comprised of inconsistent and sometimes arbitrary rules and conditions, often apparently designed to minimize the likelihood of a payout to employees . While employer-sponsored health plans had an immediate, tangible value to current workers and their families, pensions and retirement plans targeted an entirely different set of contingencies that many workers never encountered. It took more than half a century for Congress to intervene and create a set of formal conditions regulating retirement plans.
The Employee Retirement and Income Security Act of 1974, more commonly known as ERISA, spelled out the rules governing private, voluntary, employer-sponsored pensions and retirement plans. The primary function of ERISA was to protect worker rights, as well as to ensure the financial stability of plans on which workers may come to depend. Parallel to the tax code and the IRS, ERISA attempted to mitigate any potential conflict of interest between employees, employers, and those charged with managing retirement plans on their behalf .
Provisions required plan sponsors to provide sufficient disclosures to beneficiaries, as well as prohibiting certain “disqualified persons” (or “parties in interest”) from engaging in certain transactions or mismanagement of monies connected to or invested in qualified plans. Essentially, this levies an excise tax against any profits or transactions conducted which might not be in the interest of the plan’s beneficiaries, or which benefit other “disqualified persons” at the expense of the plan’s integrity. It also spelled out exemptions, disclosures, and other rules governing the management of pension/retirement plans, and defining the fiduciary responsibility of those managing such plans .
ERISA also helped add government oversight to privately-sponsored health plans, including laying the groundwork for the 1985 Consolidated Omnibus Budget Reconciliation Act, or COBRA. This law, well in advance of the ACA of 2008, described similar disclosures and obligations to provide employee health coverage following changes to their employment .
Fringe Benefits, Perks, and Incentives
While health insurance and retirement benefits were the result of major macroeconomic changes in the wake of the Industrial Revolution and World Wars, other changes and developments in non-wage compensation were the result of smaller shifts in technology and the jobs it created.
Perhaps the best example of a common perk that was previously unheard of is the company car. Today, this is the quintessential example of a fringe benefit, or a benefit that isn’t strictly monetary (like a pension or health plan) but which does provide tangible value to the employee . Fringe benefits like a company car blur lines not only on what entails “compensation” (and qualifies as taxable income), but also on the relationship between employer and employee. For example, a contractor, who does not receive a salary and is not subject to automatic withholding for tax purposes, may benefit from the use of a company car provided to support work-related activities, like remote sales. Depending on the arrangement, this contractor could feasibly use the company car both in the execution of work-related activities, as well as for personal benefit, or even for the benefit of his or her family .
These kinds of fringe benefits are broadly considered taxable, and must be reported as income for tax purposes by the provider, and recipient, of the relevant services or perks . However, there are layers of nuance to this, and an extensive list of exemptions or qualifications governing when and how these perks are reported and taxed. For example, a bonus may be offered to employees, contingent on their performance or reaching a certain goal. While this incentive payment would not be considered as part of the employee’s normal wages or salary, it would still be reported (and taxed) as part of their regular income . However, other performance-based rewards or gifts may be exempted; for example, a trophy, gift card, or other in-kind incentive valued at less than $100 would generally not need to be reported as part of the recipient’s income .
In general, the tax status of these kinds of fringe benefits that exist outside of the more clearly-defined realm of health and retirement plans are reported or exempted based on the monetary value of the gifts, services, or perks involved, as well as the nature of the benefit . For things like meal plans, transportation services, and even educational reimbursements (an increasingly popular employee benefit in a time where degrees and credentials are often a condition for employment or advancement), the IRS has outlined more specific rules on what qualifies as income, and what can be exempted or written off by both employees and employers [6, 7].
As the labor market and the American economy continue to evolve, so too do the needs, expectations, and opportunities of both workers and employers with respect to benefits and methods of compensation. Technology, bargaining power, and tax policy are all tightly connected, and can create considerable confusion as well as opportunity for those dealing with benefits issues. With your Masters of Taxation, you can help employers of all sizes, from multinational corporations to small businesses, navigate the accounting challenges brought about by modern benefits and perks. Alternatively, with an LLM in Taxation, you can guide both private and federal institutions through tax law as it relates to non-wage compensation, and help solve the emerging challenges brought on by the constant transformation of technology and business in the United States.
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