A Raise or a Benefit: You Choose

Companies that have survived the economic downturn of the past several years may be in a position now to reward employees that hung in during tough times. Many workers have not had raises in years or have even seen wages and benefits cut. Before you jump to offer a raise, think about the best way to reward your staff from a tax perspective.

The cost of a raise

When you increase a worker’s pay, it costs the company more than the actual addition to the paycheck. The company must factor in:

• The employer’s share of FICA (to cover Social Security and Medicare taxes). For 2012, the employer’s share of FICA is 6.2% on wages up to $110,100, and 1.45% on all wages.
• State unemployment insurance. Each state sets its own rates for this cost, which is collected as a tax on wages paid. (The federal unemployment tax (FUTA) is assessed only on the first $7,000 of wages, so a pay increase likely won’t impact this employer cost.)
• Benefit formulas. For example, if you make contributions to a qualified retirement plan, such as an SEP, it is based on compensation. Say you contribute 10% of employees’ compensation to the plan each year. A $2,000 wage increase means an additional $200 cost to the company.

The bottom line for the employer in giving a wage increase: figure anywhere between 15% and 50% of that increase as an extra cost to the company. In other words, a $2,000 wage increase really costs you $2,400 (if you assume a 20% cost in terms of taxes and benefits).

From the employee’s perspective, a wage increase is really worth only as much as he or she can keep after tax. If, for example, an employee is in the 25% tax bracket, a $2,000 wage increase only nets $1,500 after income tax (even less when the employee’s share of FICA is factored in).

Instead of giving a wage increase, why not offer a fringe benefit? The benefit can cost the company less — there may be no employment taxes on the benefit—while providing a valued item or service to the employee.

Tax-free benefits

The tax law has an extensive menu of fringe benefits that can be offered to employees (including owners) without any tax cost to them, or to the company. The benefit is tax deductible for the company, but there are no added employment taxes.

Here are some of the benefits that can be offered (a complete list of benefits and their employment tax treatment can be found in IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits:

• Adoption assistance
• Dependent care assistance
• Education assistance
• Group-term life insurance
• Transportation benefits (such as commuter transit passes and free parking)

The key to making most types of fringe benefits tax free to employees is that they must be offered on a nondiscriminatory basis. If, for example, you want to help with an employee’s daycare expenses, this benefit must be offered to your entire staff (with some exceptions) on the same terms and conditions. If you help only a single employee by paying for or reimbursing her daycare costs, it is taxable in the same way as if you had given a raise.

Taxable benefits

Some benefits to employees are taxable, but may still be better from a tax perspective than a pay raise. These benefits can be used to reward a specific employee; they need not be offered on a nondiscriminatory basis.

When it comes to taxable benefits, there is obviously a tax cost to the employee. However, the tax cost is less than what the employee would have to pay out-of-pocket to enjoy the same benefit. For example, if you allow an employee to drive a company car for personal purposes, such as commuting to and from work, this benefit is taxable to the employee. There are various ways for a company to figure the taxable value of this benefit (explained in Pub. 15-B). Say it works out to be $2,000 for the year. If the employee is in the 25% tax bracket, it means a tax cost of $500. In other words, for a mere $500, the employee enjoys the use of the company car for commuting; this is much less than it would cost an employee to use a personal vehicle or even public transportation for commuting.

Final thought

Before you decide to offer a raise or a benefit to an employee, talk with your tax advisor. By essentially pushing a pencil on paper, you can determine the better way — for both the company and the employee — to reward the employee for valued service.

About the Author

Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser’s Small Business Taxes and The Complete Idiot’s Guide to Starting a Home-Based Business, and trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and host of Build Your Business Radio. She has been included in the List of 100 Small Business Influencers for 2011 and 2012. Follow her on Twitter: @BarbaraWeltman.