Fringe Benefits Fringe benefits offer special deferral opportunityFringe benefits offer special deferral opportunity –Tax-free fringes (e.g., health insurance) –Long-term deferral (e.g., retirement plans) LimitationsLimitations – Benefits must usually be offered to all full- time employees –Retirement plans have maximum contribution limitations –Plans can be structured to maximize owner’s proportion of contributions

Value of Fringe Benefits Wage equivalent of fringe benefitWage equivalent of fringe benefit = fringe/(1 - tax rate) = fringe/(1 - tax rate)Example: Health insurance cost = $4,800 Tax rate = 40% Wage equivalent = $8,000

Value of Fringe Benefit Salary $8,000 Taxes - 40% (3,200) After-tax amount needed to pay health $4,800

Value to Employees Employees do not see the cost of fringesEmployees do not see the cost of fringes –As a result, they may fail to appreciate their benefit Consider an annual statement detailing all compensation paid on employees behalfConsider an annual statement detailing all compensation paid on employees behalf –Salary –Health –Retirement –Payroll taxes

Mandated Benefits Fringes such as social security, medicare, unemployment taxes, and workers compensation are mandatedFringes such as social security, medicare, unemployment taxes, and workers compensation are mandated –Both the rate and maximum compensation subject to social security has increased significantly, and probably will continue to do so –Employer ultimately pays the cost of unemployment and worker’s compensation

Nondiscrimination Fringes provided to the owner must generally be provided to all full-time employees under IRC and ERISAFringes provided to the owner must generally be provided to all full-time employees under IRC and ERISA Avoiding fringe benefitsAvoiding fringe benefits –Independent contractor –Part-time employees –Employee leasing

Health Insurance Cost of health insurance and its universal applicability make this a desirable fringeCost of health insurance and its universal applicability make this a desirable fringe –Deductibility for owner depends on business form Controlling health costsControlling health costs –Managed care –Employee-only coverage Treats single and married employees equallyTreats single and married employees equally Avoids potential for double coverageAvoids potential for double coverage

Retirement Benefits Tax AdvantagesTax Advantages –Deferral - income isn’t taxed until retirement –Bracket-shifting if in lower bracket in retirement Lower brackets in retirement has often been assumed, but is now being questioned –One reason why Roth IRA is favored

Retirement Plans Owner-advantagedOwner-advantaged –Contributions based on salary (maximum of 15% up to $170,000 of salary) –Other strategies can be used to maximize owner share of contributions

Types of Plans Defined benefit -Defined benefit - – Plan guarantees a benefit –Investment controlled by business owner through plan trustee – More costly to run, not typically preferred for start-ups Defined contributionDefined contribution –Annual contribution –Contribution is not mandated –Employee often controls investment

Comparison of Defined Benefit and Contribution Defined Defined Defined Defined Benefit Contribution Benefit Contribution Employer cont. Mandatory Optional Assets Employer Employee Investing Employer Employer/ Employee Employee Cost Expensive Less costly

401(k) Plans 401 (k) Plans are a form of defined contribution plan401 (k) Plans are a form of defined contribution plan –Often called “cash-or-deferred” arrangement. Employee decides whether to take salary or defer for retirement –Employer may or may not match a certain portion of contributions

Cafeteria Plans Fringe benefits can be funded by the employee on a pre-tax basis using a cafeteria planFringe benefits can be funded by the employee on a pre-tax basis using a cafeteria plan –Similar in nature to a 401(k) plan –Employee can choose the benefits to be funded Employee portion of health careEmployee portion of health care DentalDental Child careChild care

Cafeteria Plans Particularly well-suited for benefits highly- valued by only some employees (ex. child care).Particularly well-suited for benefits highly- valued by only some employees (ex. child care).Example: Annual child care bill $5,000 Tax rate = 40% Wage equivalent = 5,000/(1-.4) (8,333) Tax savings $ 3,333

Cafeteria Plans Tax savings come from paying cost with pre-tax, rather than after-tax dollars.Tax savings come from paying cost with pre-tax, rather than after-tax dollars. –Savings apply to income tax only; amounts are subject to payroll tax Use-it or lose-itUse-it or lose-it –Amount of salary deferred for payment of fringe is established at start of year –Amounts not used are lost –Therefore, expense needs to be predictable