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Legal Ease: Tax Advantages
September 12, 2007
How to make smart tax choices for incentive programs
By George B. Delta, Esq.
Employers often overlook federal income tax considerations when they plan and purchase incentive programs. With a little bit of tax planning, however, employers should be able to avoid unpleasant surprises and actually make an incentive program more successful. First and foremost, an employer should know that incentive prizes and awards given to individuals to reward them for their hard work and achievements are taxable as ordinary income, regardless whether the prize or award is in the form of cash, merchandise or travel. This means that they are also subject to FICA (social security) and unemployment tax.
If the prize or award is merchandise or travel instead of cash, the fair market value of the item must be included as income. What constitutes fair market value depends on the item and whether it is merchandise or travel.
The percentages below are only guidelines. Each employer or other taxpayer is entitled to determine the fair market value of merchandise or travel prizes and awards, as long as its method or approach is defensible.
Merchandise
While there is no clear and concise rule, a reasonable fair market value for most merchandise might be 70 percent of the sales (point-list) price. The 30 percent discount would reflect the marketing and fulfillment services that retailers do not incur and do not have to pass through to their customers. Thus, in simplest terms, if the cost of a watch used as an award in an incentive program is $100, its fair market value should be approximately $70.
Travel
Determining the fair market value of travel is a bit more complicated. One approach would be to compare tour costs to those of outside travel agencies on selected trips, to analyze the cost of land travel for a single traveler compared to the cost of the same travel for each person who was part of a group, and to review group travel invoices to determine what components of cost should be included in the computation of fair market value. This type of analysis indicates that the fair market value of land travel would be about 75 percent of land cost. If the employer or the incentive company purchases the airfare, then the purchase price of the ticket should also be its fair market value for income tax purposes.
More Successful Programs
As I mentioned above, an awareness of tax implications can help a company structure a more successful incentive program. To this end, an employer should consider reimbursing employees for income taxes on their awards by grossing up their wages; otherwise the taxes imposed on awards might work as a disincentive. While this may increase the cost of the program by 30 percent or so, the additional cost should lead to happier employees.
In any case, it is often preferable to give awards in the form of travel or merchandise instead of cash or cash equivalents for tax as well as business reasons. One tax advantage of merchandise or travel is that its fair market value for purposes of reporting on Form W-2 (for an employee) or 1099-MISC (for an independent contractor, such as a dealer or distributor) may be lower than its cost to the employer. Thus, the amount of tax payable by the recipient would be lower than if cash were used.
In addition, merchandise has the benefit of providing continued motivation and encouraging saving for a reward (the recipient can earn points for a more valuable prize and then can use that prize, whether it be a watch, toaster, or golf clubs, for years), creating an emotional attachment for the recipient. In any event, proper planning for income taxes can help an employer maximize its benefit from a well-structured incentive program.
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