Figuring out if your compensation is taxable can be confusing. The tax code is complicated, and it’s hard to know if you’re getting all the deductions and credits you deserve.
We created this article to help make sense of compensation taxation. In it, we cover topics like what counts as income, when you need to pay taxes on your income, and common deductions and credits that can reduce your taxable income.
Is compensation taxable? Yes, compensation is taxable. Unless you’re aware that a payment is exempt from tax, you should assume that all compensation payments are taxable wages.
Is Compensation Taxable?
The income tax and state payroll tax rules usually define taxable compensation as an employee’s wages, which are essentially all payments to a person for services rendered. You have possibly made a taxable wage payment whenever you supply anything of value to an employee in exchange for the employee’s work. Unless you’re aware that a payment qualifies for an exemption, you should assume that all payments to employees are taxable wages.
Let’s look at different types of compensation and their taxability/non-taxability nature:
Advances. Wages paid to your employees for future services or tasks are taxable wages for payroll tax purposes. Advances aren’t taxable wages if the recipients are under a legal obligation to return the funds. Advances for expenses that employees will incur while providing services for you aren’t taxable wages if they’re made on an accountable plan.
Gifts. The majority of presents you give to your workers are considered compensatory in nature. Unless you can show that a present is related to an unrelated event (such as an employee’s wedding), gifts to your employees are classified as taxable wages for payroll tax purposes. If the presents are items of property with little value (for example, a turkey or ham), don’t qualify for the exemption.
Prizes and awards. In contrast, bonuses and prizes paid to employees are usually taxed as taxable wages. A non-cash prize or award given to an employee as a length-of-service or safety-achievement reward is not taxable if the value is no more than $400 and it’s provided during the year.
Business expense reimbursements. In general, unless you use a flexible spending account or healthcare savings account to make advances and reimbursements under an accountable plan, they are taxable wages. An accountable plan must meet the following requirements:
(1) Reimbursements must be for the deductible business expenses that are paid by an employee in the course of performing services for you; The employee must be required to document the elements of amount, time, use, and business purpose; and
(2) The employee must be compelled to prove each component of the cost, duration, usage, and commercial purpose; and
(3) Any excess of reimbursements over verified expenses must be returned to you within a reasonable period of time.
Fringe benefits. The value of all non-excluded fringe benefits is considered taxable wages for payroll tax purposes, and you may be required to withhold and pay taxes on the basis of the fringe benefits’ fair market value however, the law provides a lengthy list of fringe benefits that you can give to your employees without having to pay FICA or FUTA taxes.
For income tax purposes, most of these fringe benefits are also not included in an employee’s compensation.
The following are examples of benefits that aren’t included in taxable wages: health plan payments, employer contributions to a qualified pension or retirement plan, worker’s compensation premiums and benefits, and perks with little value, such as occasional parties, supper money on occasion, or cab expenses when an employee works late.
Jury duty pay. Even though the payments are for times when employees are absent from work, amounts you pay your staff while they’re on jury duty are taxable wages for payroll tax purposes. The taxable amount, however, will vary depending on how you treat your workers’ jury duty compensation.
If you reduce a person’s usual salary by jury duty pay, payroll taxes are levied on the lowered wage amount. If you pay the regular wage but demand that employees give you jury pay, payroll taxes are calculated on only the reduced amount after taking into account the jury duty payment.
Tips and gratuities. For payroll tax purposes, the cash tips paid to your workers by your clients might be considered taxable wages. Non-cash tips, such as theater tickets, are never treated as income. Tips are gratuities given directly by consumers and without obligation on their part.
Let’s say you own a restaurant and charge a compulsory gratuity of 17% on the tab for groups of eight or more. You pay your employees with these funds, which aren’t tips. It’s not a tip; it’s a service charge that must be paid out as taxable wages when distributed to the workers.
Vacation pay. If you’ve given your workers paid vacation days, the money you pay them while they’re away is considered taxable wages, whether or not they’re on leave from work.
Furthermore, it should not come as a surprise that this same regulation applies to your payrolls for workers who do not take their vacations and instead receive extra money for the time they could have taken off.
Noncash wages. If you want to provide taxable fringe benefits, lodging, equipment, or other non-cash items to your staff, one of the first questions you should ask is how much you paid for them.
The taxable wage amount for noncash payments is the reasonable market value of the advantages or property at the time of payment.
Payments for casual labor. Occasionally, you may pay personnel to perform tasks that aren’t in line with your company’s goals. For example, you might hire someone to do some chores around your house during a slow business period.
Alternatively, you could pay one of your computer consultants to set up your home computer. Unless specific dollar thresholds are met, payments to those workers will not be taxable.
Calculating Taxes On Compensation
The taxable Compensation amount is added to the gross income and the taxes are calculated on the total value.
For instance, to calculate the after-tax income, simply subtract total taxes from the gross income. For example, let’s assume an individual makes an annual salary of $40,000 and annual compensation received is $10,000 and is taxed at a rate of 12%. It would result in taxes of $6,000 per year. Therefore, this individual’s after-tax income would be $44,000.
How To File Taxable Compensation On Your Federal Taxes?
If you worked as an independent contractor, you should receive a Form W-2 from your employer or former employer showing the compensation you received for your services. Even if you don’t receive a Form W-2 or if you do but it doesn’t contain all of your pay, include it on Line 1 of 1040 or 1040-SR.
If you worked as an independent contractor for someone else, excluding a firm that doesn’t withhold social security and Medicare taxes from your pay, you must complete Form 8919 with your Form 1040 or 1040-SR. These compensations should be shown on line 1 of Form 1040 or 1040-SR. For additional information, see IRS Form 8919.
A new Form 1099-NEC, Nonemployee Compensation, is now available for business taxpayers who pay or receive nonemployee compensation. In 2020, payers must submit this form to report any payment of $600 or more to a recipient. Payers must file Form 1099-NEC by January 31 in most cases.
The due date for 2020 tax filings is February 1, 2021. There is no provision for an automatic 30-day extension to file Form 1099-NEC. However, under certain hardship circumstances, a filing extension may be granted.
Backup withholding may be imposed on nonemployee compensation if a payer has not given a taxpayer identification number to the IRS or the recipient.
State Taxes On Compensation
State Taxation of Compensation and Benefits, examines the influence of state taxation on executive and employee compensation and benefits. The capacity for a state to claim jurisdiction over persons who generate money in connection with the rendering of services is based on the individual’s domicile or residence in the state.
In general, unless a payment is specifically exempt from taxation, you should assume that all compensation to employees is taxable wages. This includes both cash and non-cash compensation, such as meals, lodging, and other benefits. Be sure to keep track of all pay and withhold the appropriate taxes so that your employees don’t have to worry about it when tax time comes around.