Employee Benefits: Rules and OptionsJul 19, 2021
If you have employees or are thinking of hiring employees, you may be wondering what kind of benefits you can or must offer. This can be a daunting task to think about when you are new to hiring. Benefits can be costly, but may not be as costly or as involved as you have imagined. Most benefits result in a business deduction and therefore reduce the taxes you will ultimately pay.
Small businesses, usually those with 50 employees or less, are often not required to offer benefits. Benefits do create an opportunity to retain employees, enhance performance and create a positive company culture, so you may want to voluntarily offer some benefits even if you are not required to do so. Below are some rules and options to consider.
Note: this blog covers some general rules fo employee benefits in the U.S. Your state may have more strict or specific rules you need to follow. When hiring, it is wise to consult an employment attorney familiar with your state laws and practices, as well as appropriate insurance experts and a tax professional.
See also: Hiring an Employee: Steps and Resources
Hiring employees can be an overwhelming change if this is a new process. Unless required by law, consider offering a few reimbursable expenses and training at first, which are simple to process and track. The cost for these benefits is usually small and you can control the cost. As your business grows and you develop a cash reserve, you can offer other more extensive benefits.
Types of benefits
Employee benefits are not limited to health insurance and retirement plans. Here are some benefits you may consider that will be further discussed below.
- Reimbursement for expenses
- Educational expenses and student loan costs
- Employee paid time off
- Retirement benefits and profit sharing
- Life or disability insurance
- Health insurance or stipend
There are other benefits you may want to offer in addition to or instead of those listed above. See also: On Premises Employee Gym: Rules for Deduction.
Benefits are sometimes taxable to the employee as fringe benefits. This means the cost or value of the benefit is added to the employees wages and taxed as income. The IRS allows an exception for certain benefits. For a more comprehensive understanding of these rules, see the IRS Publication 15-B Employer's Tax Guide to Fringe Benefits.
Reimbursing your employees for costs they incur in working for you is a great first benefit to offer. Employees can no longer deduct unreimbursed work expenses on their taxes, and having to pay out of pocket for expenses reduces their net pay from employment. Employees may have costs for cell phone, mileage, home office, and other costs to work for your business.
If you wish to reimburse your employees for costs they must incur to work for you, there are a few steps to take.
Create an accountable plan
An accountable plan is a reimbursement policy that ensures your employees will not be taxed on the reimbursements.
A typical accountable plan will require your employees substantiate their expense and provide you with timely documentation, which you will then use to support the business deduction. In turn, the employee will not be taxed on the reimbursement amount.
You will also want a reimbursement request form for your employees to complete and to make it clear what sorts of expenses can be reimbursed. Read more about setting up an accountable plan in the Journal of Accountancy article Start or Review an Accountable Plan.
Provide a stipend
A stipend is a flat amount that you give to each employee to cover their expenses. A stipend does not require the employee to provide documentation for their exact expense. For example, if you provide a $50 cell phone stipend, your employee does not need to prove their cell phone bill was $50 or more, or even that they paid it themselves.
Stipends are taxed as income. Because the employee does not provide a receipt or bill to prove the expense, it's the same as simply paying the employee an extra amount as wages. The reason it may be differentiated between the regular salary or hourly pay is so that the employee knows that amount is specifically set aside to cover the costs.
Check your state laws to see what costs you may be required to reimburse to your employees. A California the courts have ruled that employers must reimburse employees for necessary expenses incurred to do their jobs, including reimbursing for cell phone expenses. If you are in CA, read these two articles:
Personal cell phones at work
Remote work expenses
Paying for your employees training costs is good idea. Not only can you deduct the cost, it also ensures your employees have the skills and knowledge to do the work well. The IRS has a tool to help determine if your employee or your own educational benefits can be deducted. See IRS Topic No. 513 Work-Related Educational Expenses.
You can also reimburse employees for their school tuition costs of up to $5,250 per year and the employee will not be taxed on the amount. Through 2025, you can use this plan to cover student loan payments in addition to current tuition. Owners may only get 5% of the benefit given to employees, so it does not end up being a personal benefit to the owner. However, it can help attract and retain employees and employees may be willing to accept a slightly lower salary to get this benefit.
For more information, see the IRS Publication 970 Tax Benefits for Education, section titled: "Employer-Provided Educational Assistance" on page 67.
Employee paid time off
Time off can be granted for employees who are sick, injured, have family obligations or for vacations or holidays. After considering state and local laws, you can create a time off policy that will act as an incentive to attract and retain employees as well as maximize business efficiency.
The Family Medical Leave Act (FMLA) requires that businesses with 50 or more employees, government agencies and schools provide up to 12 weeks of unpaid time off for certain family and medical reasons. Employee group health insurance benefits need to be maintained during this time. The Department of Labor has a FMLA Frequently Asked Questions page with more details. Small businesses are not required to follow this law but can optionally offer employees unpaid time off when needed.
An employer can require the employee to use accrued vacation hours as part of the FMLA leave. Employees cannot take FMLA time just to take an unpaid vacation, but may be able to travel while on FMLA. Read about two court cases in this article: Is There Anything Improper About Taking a Vacation During FMLA Leave?
The Fair Labor Standards Act does not require paid time off benefits either, though this law does govern federal minimum wage, overtime, work hours and other employment rules.
State and local laws
State and local laws can require employers to provide paid time off, sick time, vacation time, and holiday time. It's important to determine if your business is operating in a location that has such a requirement, which may be dictated by where your employees work not your main business location. More employees than ever are working from home, potentially complicating the number of employment laws a business has to consider.
According to the National Conference of State Legislators, 13 states plus Washington D.C. have laws regarding paid time off. See the state list on this article: Paid Sick Leave. Do not rely solely on this list, since laws can change and local laws can vary, being more strict than the overall state mandate.
Paid time off benefit
Offering paid time off can help attract and retain employees. It is generally good for employee morale and well being to take time off, and having paid time off can ensure it happens. Employers can also benefit when employees who have significant responsibilities take time off. Instances of employee fraud and embezzlement may be more likely to be uncovered when the employee takes a vacation.
Determine the goal
Time off can be granted to employees for vacation, sick time, parental leave, jury duty, to vote, military leave, holidays or bereavement. One paid time off policy can cover all these types of time off, or you can have a separate policy for certain types. For example, employees could accrue two weeks of general time off to cover sick time and vacation, but a separate policy could cover time off for military leave or bereavement.
Decide what you want your paid time off policy to accomplish. Policies can motivate behavior so think about the way it may impact your employees and business operations.
Create a policy
There are a few ways to structure and account for paid time off to consider, noting that above all else, the federal, state and local laws must be followed.
How time off is earned/accrued. Employees can accumulate or "accrue" paid time off based on how long they have worked for the company or how many hours worked. They can also get a set number of vacation hours/weeks based on how long the have been with the company. For example, an employee could get two weeks vacation upon completing one year of employment. Alternatively, a company can give a set number of hours/weeks for each year the employee has worked.
Wait period/leave accruals. New employees can be given a wait period during which they cannot accumulate or earn paid time off. Employers can institute leave accruals that dictate whether an employee can accrue paid time off hours while on unpaid leave.
Black out periods. An employee can dictate periods of time when an employee cannot take time off, such as a the busiest time of year.
Roll over. A paid time off policy can be structured so unused time rolls over to the next year.
Use it or lose it. This policy requires that employees use accrued vacation and it does not carry forward to a future year.
Accrual cap. Employers can also have an accrual cap, where an employee can carry over a certain amount of paid time off hours but cannot exceed a limit of hours. This keeps employees from having excessive accumulated vacation. Employers can also have mandatory vacation hours, where an employee is required to take a week or two of vacation every year, which also keeps excessive hours from being carried forward.
Leave transfers. You can permit employees to donate unused paid vacation to other employees who need it. For example, an employee who is battling cancer, but has used up all their vacation time, could receive hours from other employees who do not need their unused paid time off. Be sure employees do not experience pressure by keeping donations of time strictly confidential.
Unlimited PTO. Some companies let their employees determine the amount of paid time off to take. On the plus side, employees may feel empowered to manage their work and personal time in the most efficient manner. On the down side, employees could take advantage or feel unsure or guilty and not take time off even when needed.
Termination payout. A policy must be clear what happens to accrued paid time off when an employee ends their employment, either voluntarily or involuntarily.
You will also want to determine how and when employees must request paid time off. It can help to develop a formal request form and identify a particular process for making the request.
After checking state and local laws for paid time off requirements to ensure you are compliant with any employer obligations, ensure you:
- Inform all employees of the policy, usually via the employee handbook.
- Put procedures in place to ensure the policy is followed consistently.
- Apply the policy consistently and fairly to all employees.
Setting up a retirement plan is another way to help attract and retain employees. A retirement plan is optional for private employers. The Employee Retirement Income Security Act of 1974 (ERISA) governs rules for retirement plans. Retirement plans fall under two types:
- Defined benefit: employees can count on a specific amount each month in retirement. This amount is usually based on how long the employee worked for the company and their salary.
- Defined contribution: employees can count on a specific amount to be contributed, which does not guarantee a specific amount in retirement.
Most retirement plans for private employers these days are defined contribution plans. The employee and the employer can both contribute to the plan. There are a few common defined contribution plans:
- Simplified Employee Pension (SEP) is an employer contribution plan where the business contributes a set amount to each qualified employees retirement account based on a percentage of their salary. For example, if the percentage is set at 5%, each eligible employee will have 5% of their salary or pay contributed to their SEP account. The employer gets to deduct the contribution amount and the employee does not pay tax until the funds are withdrawn in retirement. A SEP is easy to establish and maintain.
- 401k plan is a retirement plan where the employee can contribute an amount to their own account, and the employer may or may not match a specific percent of the employees contribution. A 401k is a little more involved to create and manage.
- A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a plan for employers with 100 or fewer employees. A SIMPLE plan has lower contribution limits than a 401k, but is easy to establish.
- Profit sharing plan is a retirement program where the employers contribution to the employees retirement is discretionary and based on the employers election to share a portion of the profit. Usually the employer can elect each year to make a contribution or not.
If you are thinking of setting up a retirement plan for your employees it's a good idea to talk to a retirement expert as well as your tax professional. A number of different retirement professionals can help you establish a retirement plan, including consultants at Vanguard, Fidelity, 401k in a box, or a financial planning expert.
Life and disability benefits
To deduct group term life insurance as a benefit provided to employees the company or owner cannot be a beneficiary. Typically, a plan requires 10 employees to constitute a group term life insurance and qualify as a business deduction. A business owner cannot benefit, meaning the owner cannot deduct the cost of their own life insurance policy as a business deduction.
There are two types of disability insurance, short-term and long-term. Five states, California, Hawaii, New Jersey, New York and Rhode Island, as well as Puerto Rico, currently require employers to provide short-term disability benefits.
How the disability benefits are paid will determine if the cost is tax deductible to the business. There are three scenarios to consider:
- Employer pays the cost. If the business pays the disability premiums the business can deduct the cost. Later the employee will be taxed on any benefits. The downside of this plan is that the employee will get lower benefits, as they will be paying tax on the benefits when they might not be able to afford it.
- Employee pays with after tax dollars. The employer can provide the policy but the employee pays the cost with after tax dollars. The employer does not deduct the cost since they did not pay for the policy. Later, the benefits will not be taxed since tax was paid on the money used to purchase the premiums.
- Employee pays with after pre-tax dollars. The employer can provide the policy but the employee pays the cost with after pre-tax dollars. The employer does not deduct the cost since they did not pay for the policy. Later, the benefits will be taxed on the benefits paid, since premiums were paid with pre-tax dollars.
If you are considering providing life or disability benefits to employees, consult both an insurance broker and a tax professional.
Health insurance benefits
Health insurance coverage is an important yet potentially costly employee benefit. Generally, small businesses with 50 or fewer full time employees are not required to provide health benefits. Employers with more than 50 full time employees are not only required to offer benefits, but must ensure the benefits are affordable. The first step is understanding if you are required to offer coverage and if so, how to ensure the plan is affordable.
You may be a small business today, but if you are growing you'll want to know when you will be subject to increased rules and regulation.
Full time definition and FTEs
An employee is considered full time if they work either 1) 30 hours or more per week or 2) 130 hours per month.
A full time equivalent (FTE) calculation converts the number of part time and full time employee into a number that represents how many employees would be counted if everyone was full time. So for example, two employees working 15-20 hours per week would be one full time equivalent. Three employees each working 10-12 hours per week would be one full time equivalent.
For the IRS, the number of FTEs is calculated based on the prior calendar year. Employees hired this year will count toward next years FTE count.
The employee count does not include a self-employed owner, partner or S-Corp owner who owns 2% of more of the business.
The employee count can include independent contractors who are misclassified, meaning a worker who was treated as and paid as independent but is later determined to have been an employee. Ensure your workers are not misclassified, causing you to later be bumped over the 50 employee threshold. Read more here: Employee or Independent Contractor: Factors and Decisions.
ALEs and affordable coverage
An applicable large employer (ALE) is defined as one with more than 50 full time full time equivalent employees. These employers are not only required to provide health insurance, but the insurance coverage must be affordable.
For 2021, the IRS defines affordable as no more than 9.83% of the employees household income. At least one option under the plan has to fall under this percentage or the business could face harsh penalties. This affordability threshold is regularly updated to keep up with inflation.
Because an employer usually will not know each employees household income, there are three safe harbor methods to ensure the employer is creating an affordable plan:
- Rate of pay safe harbor using the employees hourly rate to determine if the lowest plan cost is affordable.
- Form W-2 wages safe harbor determining affordability using the wages shown in box 1 of the employees W-2.
- Federal poverty line safe harbor uses the published federal poverty line to determine if the plan is affordable.
It is best to work with your insurance agent, tax professional or attorney to ensure your plan meets the federal affordability rules if you are an ALE. For additional details see the IRS.gov Questions and Answers on Employer Shared Responsibility Provisions Under the Affordable Care Act.
Health reimbursement arrangements
Small employers (voluntarily) and large businesses (required to provide coverage) can establish a health reimbursement arrangement (HRA) for employees. An HRA is a plan whereby the employer agrees to reimburse the employee a maximum amount for actual costs incurred for premiums or other healthcare costs. Under this plan, the employee must prove the costs were incurred and provide documentation to the employer in order to get reimbursed.
Because the amounts qualify as reimbursement for specific expenses, they are not taxable as income to the employee and the employer does not pay payroll tax on these amounts. The employer can deduct the reimbursed amounts.
ALE's and affordability
An ALE can use an HSA as long as they can show the plan is affordable to the employees.
Qualified small employer HRA
A small employer, one who is not an ALE, can set up a qualified small employer health reimbursement arrangement (QSEHRA). To have a QSEHRA an employer must have 50 or fewer full time equivalent employees, offer the plan to all full time employees, and not offer a group health plan to any employees.
To learn more about establishing a QSEHRA, visit Exploring coverage options for small businesses, Health Reimbursement Arrangements (HRAs) for small employers by healthcare.gov.
Other small business options
There are a few additional options to help small business who want to offer health insurance or supplement the cost of health insurance for their employees.
Health care tax credit
There is a tax credit for small businesses offering coverage to employees, which can be taken for up to two consecutive years. A business may qualify to get a credit of up to 50% of the health care premiums if:
- Coverage is purchased though the Small Business Health Options Program (SHOP) Marketplace.
- The business has fewer than 25 full time equivalent employees
- Employees earned an average wage less than $56,000 year (for 2020, this number is set each year)
- The business paid 50% or more of the employees premiums (not counting covered family members)
The smaller the businesses, the larger the credit. For example, to get the full credit a business needs 10 or fewer employees earning an average of $27,000 or less. Businesses with more than 10 employees earning higher wages, will get a smaller credit. Taking this tax credit reduces the amount of premiums that can be deducted. You cannot have a credit and a deduction for the same dollar paid.
For more information visit the IRS.gov Small Business Health Care Tax Credit: Questions and Answers, and discuss with your insurance broker and tax professional.
Offering a stipend to assist employees to purchase their own insurance is an alternative for small businesses who cannot afford to offer health care coverage. A stipend is a set amount given to an employee, such as $150/mo. The employee cannot be required to prove that they actually spent it on healthcare coverage. This amount is taxable to the employee the same as regular pay and the employer pays payroll tax on the amount as well.
Choosing a health insurance broker
To find an appropriate health plan, you may want to consult an insurance broker to determine what health plans might work best for your business and your employees.
An insurance broker can help you explore options, choose and implement a health plan for your small business. Below are some factors to consider when choosing an insurance broker. It is helpful to consider several candidates and choose the one that best fits your needs as a small business.
- Is the broker part of a local, regional or national firm? This may determine the type of resources the broker has access to and in some cases the amount of personalization for the service provided.
- What is the brokers experience and background? It is okay to ask the specific skills and experience of the broker you are hiring.
- How is the broker compensated? The manner and amount of compensation can have implications for the cost to your business and what products you are offered during the process.
- Who does the broker represent? What companies do they work with and what products are they able to recommend? Is this list limited or expansive? Agents typically represent one company, brokers typically work with several but may not have access to all types of health plans.
- Is the broker licensed and do they have E&O insurance? You can inquire as to the brokers license and verify the license status online. Errors and Omissions (E&O) insurance products you and the broker if the broker makes errors while providing the service.
- What service do they provide to the employer and employees? Does the broker help you after the selection process? Do they have access to analytical tools to help you evaluate the plan options? Do they provide HR services to help employees with the administration of the health plan? Does the broker have depth of knowledge of your state and local, as well as federal laws related to health plans?
Consider also asking other business owners you know who they use. Do not go with the first name you get, without also considering other candidates and comparing the services they offer. You may be able to find a local or state-wide broker directory in addition to these national options:
SHRM Broker Finder
National Association of Health Underwriters
Healthcare.gov marketplace and SHOP agents/brokers
There are a myriad of employee benefits to consider offering employees. If you are new to hiring employees, know that most benefits are usually voluntary for most small businesses. Learn your state and local laws especially for required paid time off. Absent legal requirements, you can begin slow, offering employee training and expense reimbursement and build up to more involved benefits such as health insurance and retirement benefits as your business can afford those options. When you are ready to offer additional benefits, you may want to consult with an attorney, insurance expert, tax professional and perhaps a financial planner as well.
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