One way to attract new employees to your organization and retain them is to offer tax-free fringe benefits. There are two nontaxable employee fringe benefits that many employees appreciate: Dependent Care Assistance and Reimbursement of Student Loan Principal and Interest Payments. Employers get a tax deduction when they pay these benefits, but employees do not pay income tax when they receive these benefits. The amounts are also not subject to Social Security or Medicare taxes, a savings for both the employer and the employee.
Dependent Care Assistance
By adopting a Dependent Care Assistance Program (DCAP), employers can make a tax-free reimbursement to employees of up to $5,000 in qualified dependent care expenses each year. While many employers offer these plans on a salary reduction basis, there is no requirement to do so. Offering an employer-pay-all DCAP can be a valuable recruitment and retention tool. Because the employee receives a benefit in the form a tax-free reimbursement and no employment taxes are imposed on these amounts, the employer’s tax savings offsets the administrative cost of operating the program.
A DCAP works like any other business expense reimbursement program: as qualifying dependent care expenses are incurred throughout the year; employees are reimbursed for these costs. Once the maximum allowable tax-free reimbursement amount is met, reimbursed amounts would be taxable, subject to income and employment taxes. Employers may choose to limit reimbursements to the maximum tax-free benefit of $5,000.
Qualified Expenses
To qualify for a DCAP, the care must be for either: (1) a dependent child under 13 years of age or (2) a spouse or dependent who has a physical or intellectual disability and is thus incapable of self-care. Qualifying expenses include payments for services to care for the qualifying dependent. This can be in-home care (e.g., a nanny or a family member other than a child under age 19, or parent(s) who are claimed as dependents by you) or expenses for childcare outside the home (e.g., a day care center). Any expenses directly related to providing care to the dependent qualify, including employment taxes paid for a nanny, application fees for a childcare center and other items. Amounts paid to your children under the age of 19 or other individuals who can be claimed as dependents on your income tax return do not qualify for tax-free reimbursements.
Maximum Reimbursement Amount
The tax-free reimbursement amount is limited to the employee’s earned income or the lesser of the employee’s or the spouse’s earned income if the employee is married. An employer can rely on an employee’s representation that the spouse makes at least $5,000 and other items regarding this limit. Since the maximum reimbursement is capped at $5,000, this earned-income limit will not affect many people. An employer could cap the maximum reimbursement at any amount, but only expenses up to the limit can be reimbursed tax-free.
DCAP Requirements
A DCAP must be a written plan, which provides benefits to a nondiscriminatory group of employees. This can be all employees or a classification of workers that is a nondiscriminatory group. In addition to offering the plan to a nondiscriminatory group of employees, the average benefits provided to non-highly compensated employees must be at least 55% of the benefits provided to highly compensated employees. For 2022, a highly compensated employee is generally anyone who made more than $130,000 in 2021 and a non-highly compensated employee is anyone who made less than that amount. These amounts increase for cost of living annually and will rise to $135,000 for 2023. Finally, no more than 25% of the benefits paid can be provided to a 5% owner, considering ownership of all family members in determining who owns 5% of the employer.
Plan Operation
Many payroll providers assist with the operation of these plans, facilitating the inclusion of taxable amounts that may be paid under the program. There are also benefits firms that offer administration services for these plans if the employer does not want to administer the plans. Plan operation consists of reviewing submitted expenses for qualification for payment and paying appropriate expenses.
There are notice and reporting requirements for these plans. Each employer offering these plans needs to notify eligible employees of the availability and the terms of the DCAP. In addition, by January 31 each year, the employer must furnish the employee with a written statement showing the reimbursements paid to the employee in the prior tax year. Nontaxable amounts also need to be reported on the Form W-2 as a memo item.
Tax-Free Reimbursement of Student Loans
Before 2026, any amounts paid by an employer to reimburse an employee for principal and interest on a qualified education loan incurred by the employee for the employee’s education can be tax free if the employee provides substantiation to the employer of the loan repayment.
Qualified Education Loans
A qualified education loan is a loan incurred by the taxpayer to pay qualified higher education expenses, generally the cost of attendance at an eligible educational institution.
Maximum Amount to be Reimbursed
The maximum amount reimbursed for loan repayments or other educational expenses reimbursed to the employee cannot exceed $5,250 per year. Any amount paid that exceeds this limit would be taxable income, subject to income and employment taxes.
This benefit cannot be offered on a salary reduction basis, although in the hiring process one could consider whether an individual had outstanding loans that likely would be repaid and therefore reimbursed through the program. The employer cannot offer this program through any arrangement that allows employees to choose this reimbursement or other wages or benefits. The employee receiving reimbursement cannot deduct interest that has been reimbursed.
Educational Assistance Plan Requirements
This program must be part of a written educational assistance plan. Many of the discrimination rules that apply to a DCAP also apply to an educational assistance plan. The program can benefit all employees or those that are part of a classification set up by the employer which is not discriminatory in favor of highly compensated employees. The definition of highly compensated employee is the same as that used for the DCAP. For these plans, no more than 5% of the amounts paid or incurred by the employer for educational assistance can be made for individuals who are more than 5% owners of the company on any day of the year.
Eligible employees need to have reasonable notification of the availability and terms of the reimbursement.
In Summary
As the great resignation continues, employers will need to review, among other things, benefits employees find useful. DCAP and Reimbursement of Student Loan Principal and Interest can be tax free benefits that many employers will find could make a difference in hiring and retaining employees. Reach out to your CB professional to help you better understand these opportunities.
