Employee benefits, once considered an “addition” to wages, have now become an integral part of virtually all compensation packages. 

This overview evaluates the tax attributes of various employee benefit plans.

Characterization of a benefit as either bad, better, or best, can be made according to its effect upon the income taxes of the employer and the employee.

For example, assume that in 2016 we have an employer in a 34 percent marginal tax bracket and an employee in a 25 percent tax bracket. (However, for the first time in recent memory, it is possible for the corporate income tax rate to be less than the individual income tax rate. For this reason, it is very important to consider relative tax brackets when considering employee benefit planning.)

Bad. A bad employee benefit is one that is nondeductible to the employer yet taxable to the employee, such as one that results in unreasonable compensation or is treated as a dividend.

Because it is nondeductible, on each $1.00 of income the employer must pay 34 cents in taxes. Since the remaining 66 cents is taxable to the employee, 17 cents of employee taxes will further reduce the original $1.00 to only 49 cents.

Better. A better employee benefit is one that is deductible to the employer, although still taxable to the employee.

Since there are no employer taxes, the full $1.00 is taxable income to the employee. Now 25 cents goes to pay employee taxes, and the remaining 75 cents actually benefits the employee.

Better benefits include salary allotment plans, executive equity plans, split-dollar insurance, survivor income plans, disability income plans, and deferred compensation.

Best. The best employee benefit is one that is deductible to the employer and either nontaxable or tax deferred to the employee.

Now the entire $1.00 benefits the employee, without any current reduction for either employer or employee taxes.

“Best” benefits include group term insurance, medical expense reimbursement plans, SIMPLE IRAs, and qualified retirement plans, including 401(k) plans. (Specific benefits may not be available to all employees and employers. Although SIMPLE IRAs and qualified retirement plans, including 401(k) plans, are listed among the “best,” it must be recognized that the employee pays taxes when retirement income is actually received. Tax-free group term insurance is limited to $50,000 of coverage. The term leveraged benefit can be used to describe some of the best employee benefits.)