Employee Compensation
This section discusses many types of employee compensation followed by a detailed explanation of fringe benefits.
If you are an employee, you should receive Form W-2 from your employer showing the pay you received for your services. Include your pay on
line 7 of Form 1040 or Form 1040A, or on line 1 of Form 1040EZ, even if you do not receive a Form W-2.
Child-care providers.
If you provide child care, either in the child's home or in your home or other place of business, the pay you receive must be included in your
income. If you are not an employee, you are probably self-employed and must include payments for your services on Schedule C (Form 1040), Profit
or Loss From Business, or Schedule C-EZ (Form 1040), Net Profit From Business. You are generally not an employee unless you are
subject to the will and control of the person who employs you as to what you are to do and how you are to do it.
Baby sitting.
If you baby sit for relatives or neighborhood children, whether on a regular basis or only periodically, the rules for child-care providers apply
to you.
Miscellaneous Compensation
This section discusses many types of employee compensation. The subjects are arranged in alphabetical order.
Advance commissions and other earnings.
If you receive advance commissions or other amounts for services to be performed in the future and you are a cash method taxpayer, you must include
these amounts in your income in the year you receive them.
If you repay unearned commissions or other amounts in the same year you receive them, reduce the amount included in your income by the repayment.
If you repay them in a later tax year, you can deduct the repayment as an itemized deduction on your Schedule A (Form 1040), or you may be able to
take a credit for that year. See Repayments in chapter 13.
Allowances and reimbursements.
If you receive travel, transportation, or other business expense allowances or reimbursements from your employer, get Publication 463. If you are
reimbursed for moving expenses, get Publication 521, Moving Expenses.
Back pay awards.
Include in income amounts you are awarded in a settlement or judgment for back pay. These include payments made to you for damages, unpaid life
insurance premiums, and unpaid health insurance premiums. They should be reported to you by your employer on Form W-2.
Bonuses and awards.
Bonuses or awards you receive for outstanding work are included in your income and should be shown on your Form W-2. These include prizes
such as vacation trips for meeting sales goals. If the prize or award you receive is goods or services, you must include the fair market value of the
goods or services in your income. However, if your employer merely promises to pay you a bonus or award at some future time, it is not taxable until
you receive it or it is made available to you.
Employee achievement award.
If you receive tangible personal property (other than cash, a gift certificate, or an equivalent item) as an award for length of service or safety
achievement, you can generally exclude its value from your income. However, the amount you can exclude is limited to your employer's cost and cannot
be more than $1,600 ($400 for awards that are not qualified plan awards) for all such awards you receive during the year. Your employer can tell you
whether your award is a qualified plan award. Your employer must make the award as part of a meaningful presentation, under conditions and
circumstances that do not create a significant likelihood of it being disguised pay.
However, the exclusion does not apply to the following awards.
- A length-of-service award if you received it for less than 5 years of service or if you received another length-of-service award during the
year or the previous 4 years.
- A safety achievement award if you are a manager, administrator, clerical employee, or other professional employee or if more than 10% of
eligible employees previously received safety achievement awards during the year.
Example.
Ben Green received three employee achievement awards during the year: a nonqualified plan award of a watch valued at $250, and two qualified plan
awards of a stereo valued at $1,000 and a set of golf clubs valued at $500. Assuming that the requirements for qualified plan awards are otherwise
satisfied, each award by itself would be excluded from income. However, since the $1,750 total value of the awards is more than $1,600, Ben must
include $150 ($1,750 - $1,600) in his income.
Government cost-of-living allowances.
Cost-of-living allowances are generally included in your income. However, they are not included in your income if you are a federal civilian
employee or a federal court employee who is stationed in Alaska, Hawaii, or outside the United States.
Allowances and differentials that increase your basic pay as an incentive for taking a less desirable post of duty are part of your compensation
and must be included in income. For example, your compensation includes Foreign Post, Foreign Service, and Overseas Tropical differentials. For more
information, get Publication 516, U.S. Government Civilian Employees Stationed Abroad.
Note received for services.
If your employer gives you a secured note as payment for your services, you must include the fair market value (usually the discount value) of the
note in your income for the year you receive it. When you later receive payments on the note, a proportionate part of each payment is the recovery of
the fair market value that you previously included in your income. Do not include that part again in your income. Include the rest of the payment in
your income in the year of payment.
If your employer gives you an unsecured note as payment for your services, payments on the note that are credited toward the principal amount of
the note are compensation income when you receive them.
Retirement plan contributions.
Your employer's contributions to a qualified retirement plan for you are not included in income at the time contributed. (Your employer can tell
you whether your retirement plan is qualified.) However, the cost of life insurance coverage included in the plan may have to be included. See
Group-Term Life Insurance Premiums, later, under Fringe Benefits.
If your employer pays into a nonqualified plan for you, you generally must include the contributions in your income as wages for the tax year in
which the contributions are made. However, if your interest in the plan is subject to a substantial risk of forfeiture (meaning you have a good chance
of losing it) at the time of contribution, do not include the value of your interest in your income until it is no longer subject to a substantial
risk of forfeiture.
Elective deferrals.
If you chose to set aside part of your pay for retirement under a qualified deferred compensation arrangement (for example, a section 401(k) plan),
the amount you set aside (called an elective deferral) is treated as an employer contribution to a qualified plan, subject to a limit. For 2002, this
limit is $11,000 for all elective deferrals. If you set aside more than $11,000, the excess generally must be included in your income for that year.
This limit will increase by $1,000 each year until it reaches $15,000 in 2006. See Publication 525 for a discussion of the tax treatment of corrective
distributions of excess deferrals.
You may be allowed an additional elective deferral if you are age 50 or older. See Publication 590, Individual Retirement Arrangements
(IRAs), for more information.
Elective deferrals are not excluded from wages for social security and Medicare taxes and benefits.
If you are a federal employee, this treatment applies to your contributions to the Thrift Savings Plan.
Severance pay.
Amounts you receive as severance pay are taxable. A lump-sum payment for cancellation of your employment contract must be included in your income
in the tax year you receive it.
Accrued leave payment.
If you are a federal employee and receive a lump-sum payment for accrued annual leave when you retire or resign, this amount will be included as
wages on your Form W-2.
If you resign from one agency and are reemployed by another agency, you may have to repay part of your lump-sum annual leave payment to the second
agency. You can reduce gross wages by the amount you repaid in the same tax year in which you received it. Attach to your tax return a copy of the
receipt or statement given to you by the agency you repaid to explain the difference between the wages on the return and the wages on your Forms
W-2.
Outplacement services.
If you choose to accept a reduced amount of severance pay so that you can receive outplacement services (such as training in resumé writing
and interview techniques), you must include the unreduced amount of the severance pay in income.
However, you can deduct the value of these outplacement services (up to the difference between the severance pay included in income and the amount
actually received) as a miscellaneous deduction (subject to the 2% limit) on Schedule A (Form 1040).
Sick pay.
Pay you receive from your employer while you are sick or injured is part of your salary or wages. In addition, you must include in your income sick
pay benefits received from any of the following payers.
- A welfare fund.
- A state sickness or disability fund.
- An association of employers or employees.
- An insurance company, if your employer paid for the plan.
However, if you paid the premiums on an accident or health insurance policy, the benefits you receive under the policy are not taxable.
Social security and Medicare taxes paid by employer.
If you and your employer have an agreement that your employer pays your social security and Medicare taxes without deducting them from your gross
wages, you must report the amount of tax paid for you as taxable wages on your tax return. The payment is also treated as wages for figuring your
social security and Medicare taxes and your social security and Medicare benefits. However, these payments are not treated as social security and
Medicare wages if you are a household worker or a farm worker.
Stock appreciation rights.
Do not include a stock appreciation right granted by your employer in income until you exercise (use) the right. When you use the right, you are
entitled to a cash payment equal to the fair market value of the corporation's stock on the date of use minus the fair market value on the date the
right was granted. You include the cash payment in your income in the year you use the right.
Stock options.
If you receive a nonstatutory option to buy or sell stock or other property as payment for your services, you will usually have income either when
you receive the option or when you exercise the option (use it to buy or sell the stock or other property). However, if your option is a statutory
stock option, you usually will not have any income until you sell or exchange your stock. Your employer can tell you which kind of option you hold.
For details, get Publication 525.
Restricted property.
Generally, if you receive property for your services, you must include its fair market value in your income in the year you receive the property.
However, if you receive stock or other property that has certain restrictions that affect its value, you may not have to include the value of the
property in your income in the year you receive it. For details, see Restricted Property in Publication 525.
Dividends you receive on restricted stock are extra compensation to you. Your employer should include these payments on your Form W-2.
Stock you chose to include in income.
Dividends you receive on restricted stock you chose to include in your income in the year transferred are treated the same as any other dividends.
Report them on your return as dividends. For a discussion of dividends, see chapter 9.
For information on how to treat dividends reported on both your Form W-2 and Form 1099-DIV, see Dividends received on restricted
stock in Publication 525.
Fringe Benefits
Fringe benefits you receive in connection with the performance of your services are included in your income as compensation unless you pay fair
market value for them or they are specifically excluded by law. Abstaining from the performance of services (for example, under a covenant not to
compete) is treated as the performance of services for purposes of these rules.
Accounting period.
You must use the same accounting period your employer uses to report your taxable noncash fringe benefits. Your employer has the option to report
taxable noncash fringe benefits by using either of the following rules.
- The general rule: benefits are reported for a full calendar year (January 1- December 31).
- The special accounting period rule: benefits provided during the last 2 months of the calendar year (or any shorter period) are
treated as paid during the following calendar year. For example, each year your employer reports the value of benefits provided during the last 2
months of the prior year and the first 10 months of the current year.
Your employer does not have to use the same accounting period for each fringe benefit, but must use the same period for all employees who receive a particular benefit.
You must use the same accounting period that you use to report the benefit to claim an employee business deduction (for use of a car, for example).
Form W-2.
Your employer reports your taxable fringe benefits in box 1 (Wages, tips, other compensation) of Form W-2. The total value of your
fringe benefits may also be noted in box 12. The value of your fringe benefits may be added to your other compensation on one Form W-2, or you
may receive a separate Form W-2 showing just the value of your fringe benefits in box 1 with a notation in box 12.
Accident or Health Plan
Generally, the value of accident or health plan coverage provided to you by your employer is not included in your income. Benefits you receive from
the plan are generally taxable, as explained later under Sickness and Injury Benefits.
Long-term care coverage.
Contributions by your employer to provide coverage for long-term care services are generally not included in income. However, contributions made
through a flexible spending or similar arrangement (such as a cafeteria plan) must be included in your income. This amount will be reported as wages
in box 1 of your Form W-2.
Contributions you make to the plan are discussed in Publication 502, Medical and Dental Expenses.
Archer MSA contributions.
Contributions by your employer to your Archer MSA (previously called a medical savings account) are not included in your income. Their total will
be reported in box 12 of Form W-2 with code R. You must report this amount on Form 8853, Archer MSAs and Long-Term Care Insurance
Contracts. Attach the form to your return.
If your employer does not make contributions to your MSA, you can make your own contributions to your MSA. These contributions are discussed in
Publication 969, Medical Savings Accounts (MSAs). Also, see Form 8853.
Adoption Assistance
You may be able to exclude from income amounts paid or expenses incurred by your employer for qualified adoption expenses in connection with your
adoption of an eligible child. See Publication 968, Tax Benefits for Adoption, for more information.
Adoption benefits are reported by your employer in box 12 of Form W-2 with code T. They are also included as social security and Medicare
wages in boxes 3 and 5. However, they are not included as wages in box 1. To determine the taxable and nontaxable amounts, you must complete Part III
of Form 8839, Qualified Adoption Expenses. Attach the form to your return.
De Minimis (Minimal) Benefits
If your employer provides you with a product or service and the cost of it is so small that it would be unreasonable for the employer to account
for it, the value is not included in your income. Generally, the value of benefits such as discounts at company cafeterias, cab fares home when
working overtime, and company picnics are not included in your income.
Holiday gifts.
If your employer gives you a turkey, ham, or other item of nominal value at Christmas or other holidays, do
not include the value of the gift in your income. However, if your employer gives you cash, a gift certificate, or a similar item that you can easily
exchange for cash, you include the value of that gift as extra salary or wages regardless of the amount involved.
Educational Assistance
You can exclude from your income up to $5,250 of qualified employer-provided educational assistance. The exclusion applies to undergraduate and
graduate-level courses. For more information, see Publication 508, Tax Benefits for Work-Related Education.
Employer-Provided Vehicles
If your employer provides a car (or other highway motor vehicle) to you, your personal use of the car is usually a taxable noncash fringe benefit.
Your employer must determine the actual value of this fringe benefit to include in your income.
Certain employer-provided transportation can be excluded from gross income. See the discussion on Transportation, next.
Transportation
If your employer provides you with a qualified transportation fringe benefit, it can be excluded from your income, up to certain limits. A
qualified transportation fringe benefit is:
- Transportation in a commuter highway vehicle (such as a van) between your home and work place,
- A transit pass, or
- Qualified parking.
Cash reimbursement by your employer for these expenses under a bona fide reimbursement arrangement is also excludable. However, cash
reimbursement for a transit pass is excludable only if a voucher or similar item that can be exchanged only for a transit pass is not readily
available for direct distribution to you.
Exclusion limit.
The exclusion for commuter highway vehicle transportation and transit pass fringe benefits cannot be more than a total of $100 a month, regardless
of the total value of both benefits.
The exclusion for the qualified parking fringe benefit cannot be more than $185 a month, regardless of its value.
If the benefits have a value that is more than these limits, the excess must be included in your income.
Commuter highway vehicle.
This is a highway vehicle that seats at least six adults (not including the driver). At least 80% of the vehicle's mileage must reasonably be
expected to be:
- For transporting employees between their homes and work place, and
- On trips during which employees occupy at least half of the vehicle's adult seating capacity (not including the driver).
Transit pass.
This is any pass, token, farecard, voucher, or similar item entitling a person to ride mass transit (whether public or private) free or at a
reduced rate or to ride in a commuter highway vehicle operated by a person in the business of transporting persons for compensation.
Qualified parking.
This is parking provided to an employee at or near the employer's place of business. It also includes parking provided on or near a location from
which the employee commutes to work in a commuter highway vehicle or carpool. It does not include parking at or near the employee's home.
Group-Term Life Insurance Premiums
Generally, the cost of up to $50,000 of group-term life insurance coverage provided to you by your employer (or former employer) is not included in
your income. However, you must include in income the cost of employer-provided insurance that is more than the cost of $50,000 of coverage.
If you pay any part of the cost of the insurance, your entire payment reduces, dollar for dollar, the amount you would otherwise include in your
income. However, you cannot reduce the amount to include in your income by:
- Payments for coverage in a different tax year,
- Payments for coverage through a cafeteria plan, unless the payments are after-tax contributions, or
- Payments for coverage not taxed to you because of the exceptions discussed later in Entire cost excluded.
The amount included in your income is reported as part of your wages in box 1 of your Form W-2. It is also shown separately in box 12 with
code C.
Group-term life insurance.
This insurance is term life insurance protection (insurance for a fixed period of time) that:
- Provides a general death benefit,
- Is provided to a group of employees,
- Is provided under a policy carried by the employer, and
- Provides an amount of insurance for each employee based on a formula that prevents individual selection.
Permanent benefits.
If your group-term life insurance policy includes permanent benefits, such as a paid-up or cash surrender value, you must include in your income,
as wages, the cost of the permanent benefits minus the amount you pay for them. Your employer should be able to tell you the amount to include in your
income.
Accidental death benefits.
Insurance that provides accidental or other death benefits but does not provide general death benefits (travel insurance, for example) is not
group-term life insurance.
Entire cost excluded.
You are not taxed on the cost of group-term life insurance if any of the following circumstances apply.
- You are permanently and totally disabled and have ended your employment.
- Your employer is the beneficiary of the policy for the entire period the insurance is in force during the tax year.
- A charitable organization (defined in chapter 26) is the only beneficiary of the policy for the entire period the insurance is in force
during the tax year. (You are not entitled to a deduction for a charitable contribution for naming a charitable organization as the beneficiary of
your policy.)
Entire cost taxed.
You are taxed on the entire cost of group-term life insurance if either of the following circumstances apply.
- The insurance is provided by your employer through a qualified employees' trust, such as a pension trust or a qualified annuity
plan.
- You are a key employee and your employer's plan discriminates in favor of key employees.
Life insurance agents.
Full-time life insurance agents who are considered employees for social security and Medicare tax withholding purposes are treated as employees in
applying the provisions relating to group-term life insurance under a policy carried by their employer.
More than $50,000 from one employer.
If you have only one employer and you were insured at any time during the tax year for more than $50,000 under a group-term life insurance policy,
your taxable income from this source is included as other compensation on the Form W-2 you receive.
More than $50,000 from two or more employers.
If two or more employers provide you group-term life insurance coverage totaling more than $50,000, you must figure how much to include in your
income. You must include the cost of life insurance provided to you during the tax year, regardless of when your employers paid the premiums.
Figuring the taxable cost.
You figure the taxable cost for each month of coverage by multiplying the number of thousands of dollars of insurance coverage for the month
(figured to the nearest tenth), less 50, by the cost from the following table. Use your age on the last day of the tax year. You must prorate the cost
from the table if less than a full month of coverage is involved.
COST PER $1,000 OF PROTECTION FOR ONE MONTH
| Age |
Cost |
| Under 25 |
$ .05 |
| 25 through 29 |
.06 |
| 30 through 34 |
.08 |
| 35 through 39 |
.09 |
| 40 through 44 |
.10 |
| 45 through 49 |
.15 |
| 50 through 54 |
.23 |
| 55 through 59 |
.43 |
| 60 through 64 |
.66 |
| 65 through 69 |
1.27 |
| 70 and older |
2.06 |
Example.
You are 51 years old and work for employers A and B. Both employers provide group-term life insurance coverage for you for the entire year. Your
coverage is $35,000 with employer A and $45,000 with employer B. You pay premiums of $4.15 a month under the employer B group plan. You figure the
amount to include in your income as follows:
| Employer A coverage (in thousands) |
$35 |
| Employer B coverage (in thousands) |
+ 45 |
| Total coverage (in thousands) |
$80 |
| Minus: Exclusion (in thousands) |
- 50 |
| Excess amount (in thousands) |
$30 |
| Multiply by cost per $1,000 per month, age 51 (from table) |
× .23 |
| Cost of excess insurance for 1 month |
$6.90 |
| Multiply by number of full months coverage at this cost |
× 12 |
| Cost of excess insurance for tax year |
$82.80 |
| Minus: Premiums you paid ($4.15 × 12 months) |
- 49.80 |
| Cost to include in income as wages |
$33.00 |
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