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Talking Tax: Employee discounts can be taxable income

Q: I have a small dental practice in Twin Falls. One of my dentist friends was recently audited by the IRS, and she and her employees had to pay additional tax because the employees and their families paid less than the normal rates for dental services. Why would they have to pay more tax when she charged less? I do the same for my employees and am concerned I may have the same problem.

A: There are very specific rules on providing discounts to employees under the fringe benefit provisions of the Tax Code. While these rules certainly apply to your business as a dentist, they actually apply to any business that offers employee discounts on either goods or services.

Generally we are taxed on all income we receive from any source unless there is a specific exclusion in the law. And income is very broadly defined, so it includes money as well as other economic benefits we receive. Employees who are given a discount off the regular price of a service are actually receiving an economic benefit by way of not having to pay the full price for the service they are receiving. As an example, if the normal cost of a dental procedure is $100, but the employee is only charged $90, the employee has received an economic benefit of $10. Absent a specific exclusion in the Tax Code, this $10 benefit would be considered taxable income to the employee.

Fortunately, the law does provide for certain exclusions from this harsh treatment. The first of these rules pertains to the “no-additional-cost service.” This is a service that is normally offered to a company’s customers in the ordinary course of business, and where the company incurs no substantial additional costs in providing the service to the employee.

While this might seem to apply to a dental practice, there is a catch. This rule will only apply to “excess capacity services.” These are services such as a seat on an airplane, train or bus that would otherwise go empty if not given to an employee. But professional services such as medical, legal or accounting services are not eligible for this exemption.

Employee discounts on services not falling under the “no-additional-cost service” exemption can still be treated as non-taxable fringe benefits, but only to the extent that the discount is no more than 20 percent of the normal price of the service (the 20 percent discount rule also applies to the purchase of goods by an employee). So in my example above, the $10 discount would not be taxable since it is only a 10 percent discount off the regular price.

However, if the employee only paid $75 for a service that normally costs the general public $100, there would be taxable income triggered. Of the total discount of $25, the first 20 percent ($20) would be excluded, but the remaining $5 would be taxable income to the employee.

So your dentist friend was most likely providing services to employees at a more than 20 percent discount. As a result, the IRS examiner would want to include any discount more than 20 percent in the employees’ taxable wages and also assess additional payroll taxes (Social Security and Medicare tax).

But for health care businesses such as a dental practice, there is another aspect that the IRS apparently overlooked in the audit you described. Employer-provided health care benefits are a tax-free fringe benefit under other Tax Code provisions. Our firm encountered an IRS exam of a dentist who was providing gratis dental work to his employees. The IRS initially asserted that most of these services (other than the 20 percent portion) were a taxable benefit. But the issue evaporated when we reminded the examiner of the special tax-free fringe rules for health care benefits.

These fringe benefit rules can be complex, so be sure to check with your tax adviser to see what applies to your business and how to avoid problems in the future. And don’t forget to gently remind your employees of the nice tax-free benefit they are getting. Employees often forget that these fringe benefits really are part of their total compensation

To ensure compliance imposed by IRS Circular 230, any U. S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.

Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.

Have a question for Robbins? Email your question to news@idahobusinessreview.com. Enter “Talking Tax” in the subject line.

About Peter G. Robbins, CPA