Parties, gifts, happy workers and tax deductions.
By Mark E. Battersby
The season for gift-giving and holiday parties is fast approaching. And although many specialty fabrics products business owners and managers clearly know how to celebrate and show their appreciation to both customers and employees, few are aware that Uncle Sam, in the form of U.S. tax laws, is more than happy to pick up part of the cost.
While parties, business gifts and employee awards often qualify as tax deductible, giving gifts, bonuses or awards to employees, clients or customers can have significant tax implications for both the specialty fabrics operation and the recipients. Bottom line: everyone should be happy to know that the annual employee holiday party may be 100 percent tax deductible.
Business owners often give gifts to clients and customers, particularly around the holidays. What is often overlooked is that only a portion of the cost of certain gifts may be deducted as a business expense.
Basically, the IRS will let a business deduct only $25 or less for business gifts given to any one person during the tax year. This means that any number of employees, co-owners or business partners may give a client business gifts, although the deduction will be limited to $25 per recipient. Any amount of expense in excess of $25 is disallowed as a deduction. For example, if a client is given a $50 watch as a gift, only $25 may be deducted.
The $25 limit for business gifts doesn’t include incidental costs—for example, packaging, insurance and mailing costs, or the cost of engraving jewelry. Related costs are considered incidental only if they don’t add some kind of substantial value to a gift.
If key chains or pens with the name of the business on them are given to customers and clients, they are usually exceptions to the $25 limits for business gifts, and their cost is deductible without limitation. Also excepted are items that cost $4 or less, have the business’s name clearly and permanently imprinted on them, and are one of a number of identical items widely distributed. Signs, display racks or other promotional material to be used on the business premises of the recipient are also ignored for purposes of the $25 limit.
It’s generally known that tax rules allow professionals to claim a deduction for only 50 percent of business meal entertainment expenses. In fact, in order to be even 50 percent deductible, those meal and entertainment expenses need to be “ordinary and necessary” as well as closely related to the business. And even if the expenses are considered related to the business, the sky is definitely not the limit. No business can deduct meal and entertainment expenses that are lavish or extravagant. The expenses must be reasonable considering the facts and circumstances.
Holiday parties, annual picnics or summer outings may qualify for a unique 100 percent tax deduction. Even employee meetings can be turned into a party for a tax deduction.
Under existing tax rules, entertainment expenses must be primarily for the benefit of employees—other than those in a so-called “tainted group.” The tainted group consists of any employee paid more than $110,000 a year, a 10 percent owner, or any family member of a 10 percent owner.
While the owner of a closely-held business belongs to the tainted group, it may not matter as long as the partying with the employees is primarily (more than 50 percent) for the benefit of the employees. Going one step further, the cost of entertaining employees’ spouses is also 100 percent deductible.
It is still necessary to satisfy the “ordinary and necessary” business purpose test, which simply means an expense that is “appropriate and helpful” to the business. Boosting the morale of workers, helping everyone feel appreciated, makes that Christmas party 100 percent deductible.
Just as any entertainment must be documented, the 100 percent deductible employee entertainment expenses must be substantiated. Remember to write down the “who, what, when, where and why.” Like all tax deductions, the write-off can’t be nailed down without writing it down.
Employee business gifts
Bonuses to employees are usually considered income, and while obviously tax deductible for the business, they are taxable to the employee. Income taxes and FICA taxes on employee bonuses (unless the employee is over the Social Security maximum for the year) must be withheld.
It’s a slightly different story when it comes to employee awards. In general, up to $400 of the cost for employee awards of tangible personal property (like a watch) for each employee each year can be deducted. This includes service awards and safety awards. There are, unfortunately, limits on employee awards given by partnerships.
Service and safety awards are not taxable to employees if they are limited. There are limits on service awards (not during the first five years, and not more often than every five years) and safety awards (not to more than 10 percent of employees). Awards in excess of the limits are taxable to the recipient.
Gift certificates and gift cards are, for the most part, taxable to employees because they can be converted to cash. While there has been no official guidance regarding small-amount gift cards and certificates ($25 or less), they often qualify as de minimis fringe benefits. However, in general, if gift cards or gift certificates are given, taxes must be withheld from the employee’s pay.
Grossing up bonuses
Every business manager considering appropriate employee holiday gifts should keep in mind not only what they’ll enjoy but also how taxes will come into play. Because a gift is often considered by the IRS to be compensation, it’s important to note the rules so employees are not responsible for paying taxes on their gifts.
Employee gifts are usually small enough that the business does not need to worry about employees wanting to change their withholding allowances. For larger bonuses, however, employees should be given the options of changing their Form W-4 withholding deduction amount for that one paycheck.
While some employees may want to change their withholding to receive more of the bonus, in many cases, employers will “gross up” a bonus. That is, give the employee more to allow for withholding. For example, if an employee is given a $1,000 bonus, by the time taxes are taken out, the bonus check might be only $750. Giving a higher amount for the bonus can result in a bonus check that shows the full $1,000.
Tax free, tax deductible
Among the options that will ensure employees won’t face a tax on their holiday gifts are smaller gifts. Whether for customers or employees, gifts less than $25 are tax-exempt. If this is the amount typically spent on each employee, there are no tax concerns.
Taxes also are not a factor if the holiday gift is a reward for service, such as for achieving the highest sales, or for longevity (the employee has been with the company for 10 years). If your gift to employees is a charitable contribution in their names, there is no worry about taxes, no matter the amount.
If the business produces products that employees might enjoy, giving products or services as gifts can mean not having to pay taxes on them. In the case of a specialty fabrics business, this might be a good opportunity to get creative. Keep in mind, however, that merchandise given to either customers or employees may be subject to sales tax even though they are not for resale. It is the rule in many states.
Taking a group of employees, such as the management team, to an event usually means that the cost will be tax-free. But remember, the rules say that the group can’t consist only of family members involved with the business if is a tax-free business expense.
Before and during the holiday season, always keep in mind the role taxes play. Those businesses considering a small gift for employees—fruit baskets, hams, turkeys, wine, flowers and entertainment tickets, such as for a show or sporting event—will find they are generally nontaxable de minimis fringes and tax deductible by the business.
The cost of occasional parties is nontaxable to employees and their families as a de minimis fringe—if they are infrequent and for the purpose of promoting employee health, good will, contentment or efficiency. Occasional holiday celebrations, cocktail parties and company picnics are fully tax deductible by the business and are not subject to the 50 percent limit on business meals. For many businesses, however, the holidays mean a combination of small and large gifts and events, and it’s wise to consult a tax advisor.