IRS Clarifies Rules on Employee Discounts Offered to Friends and Family
In a Field Attorney Advice Memorandum released by the IRS on March 24, 2017, the IRS addressed the tax consequences of a fringe benefit program where a company allowed its employees to designate a limited number of individuals, without regard to their relationship to the employee, to rent property at a discount. While your facts may differ from these, this guidance helps clarify how the employee discount rules should be applied.
Qualified Discounts in General
Under Section 132(a)(2) of the Code, gross income does not include the value of a “qualified employee discount.” A qualified employee discount is a discount provided to an employee on qualified services or property that does not exceed a threshold amount. The threshold amount for property is determined by the employer’s profit. For services, the threshold amount equals 20% of the price at which the services are offered by the employer to its customers. Any discount exceeding the threshold is taxable income to the employee. To be qualified, the services or property (excluding real estate or investment property) must be offered for sale to customers in the ordinary course of the employer’s business in which the employee normally works. The definition of “employee” for this purpose includes: (i) current and retired employees; (ii) employees who separated from service due to a disability, (iii) widows, and (iv) spouses and dependent children.
IRS Memo Clarifying Qualified Employee Discount Rules
The IRS memo addresses three issues:
1. Whether the discount is on services or property for purposes of determining the applicable threshold in which employee discounts are taxable?
While the heavily redacted memo does not reveal the nature of the employer’s business, one can gleam that the employer is in the business of renting property. Based on the facts, the IRS concluded that the rentals should be characterized as the sale of a service and the qualified employee discount could not exceed 20% of the rental price offered to the employer’s customers. Accordingly, the employer is not treated as selling property, in which the qualified employee discount would be measured by its profits.
2. Whether the entire program is tainted by the inclusion of non-employees or whether the qualifying discounts provided to “employees” (as defined by the statute) continue to be excludible under Section 132(a)(2)?
The IRS concluded that the nontaxable benefit only applies to persons who fall within the definition of “employee” (e.g., current and retired employees, spouses and dependent children). However, the value of any discount provided to an individual who does not fit within the definition of “employee” for this purpose is taxable income to the employee who designated such individual. Accordingly, extending the discount to nonemployees does not adversely affect the discounts available to employees.
3. Which offering price should be used to measure the employee discount – the employer’s published rate or the discounted price provided to discrete customers or consumer groups?
Nontaxable qualified employee discounts on services cannot exceed 20 percent of the price at which services are offered by the employer to the employer’s customers at the time of the employee’s purchase. The offering price used to determine the 20 percent limit can take into account discounts offered to discrete customers or to consumer groups, provided the sales at such discounted prices comprise at least 35 percent of the employer’s gross sales for a representative period. Since the employer failed to provide sufficient information to determine whether the 35 percent standard was satisfied, the memo concludes that the employer’s published rates must be used as the basis for determining the taxable excess discount.
Notably, the discounted price could have resulted in less taxable income. Assume, for example, an employer sells services to an employee for $70 that is ordinarily sold to its customers for $100 (a 30 percent discount). The employer would report $10 taxable income to the employee ($30 discount less the $20 limit). Assume further, that the employer sells its services to discrete customers for $90 (a 10 percent discount), which represents more than 35 percent of its gross sales. The employer would report $2 taxable income to the employee ($20 discount less the $18 limit).
Presumably, this method may also be used to determine the amount to include in an employee’s income for discounts provided the employee’s friends.
Action Items
While it is favorable that the extension of discounts to the employees’ friends as well as their family members does not make all discounts taxable, such a design diminishes the value of the program to the employees and complicates plan administration for the employer.
From an employee’s perspective, the value of the discounts provided to the employee’s friends will be treated as additional wages in which taxes on such benefits must be withheld from the employee’s paycheck; while the friends enjoy the fringe benefits without incurring any tax liability. If an employer extends its “qualified employee discount” program to nonemployees, it should notify the employees about the tax consequences of designating such individuals to participate in the program.
From the employer’s perspective, additional employment taxes attributable to the discounts provided to the employees’ friends will be incurred by the employer. Plan administration also becomes more burdensome since an employee’s relationship with each person designated to participate in the discount program must be tracked so that the employee’s taxable income can be properly calculated, reported and withheld upon.
For administrative simplification, employers may wish to limit their “qualified employee discount” programs to active employees, retirees, and their spouses and dependent children to avoid having to identify nonemployees participating in the program and imputing income to the employees for their use.
Further, if the employee’s discount is based on a discounted price provided to discrete customers or consumer groups, rather than the published rates, the employer should maintain records that (i) establish that 35 percent of the employer’s sales are comprised of discounted rates given to such customers, and (ii) show each group’s discount and the percentage of sales that each group contributes to the total sales. Absent such showing in an audit, the IRS agents are instructed to base the employee’s discount off of the published rates, which may result in higher income inclusion for the employee.
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