Which tax-free and tax-favored fringe benefits are passthrough owners entitled to?
Partnerships, LLCs treated as partnerships, and S corporations have distinct tax and nontax advantages. However, entrepreneurs considering these forms of business should be aware that fewer tax-free and tax-favored fringe benefits are available to owner-entrepreneurs of passthroughs than to shareholder-employees of C corporations. This Practice Alert reviews which fringe benefits can be made available on a tax-preferred basis to partners, members of LLCs taxed as partnerships, and more-than-2% S shareholder-employees. It helps practitioners advise clients who are thinking of operating a business as a passthrough, or are operating as a passthrough and are looking for ways to maximize their tax-free compensation.
Note that the statutory rules allowing or denying fringe benefits to passthrough owners are stated explicitly only in the context of partners and partnerships. However, under the default classification rules of Reg. § 301.7701-3(b)(1)(i), a domestic eligible entity with two or more members automatically is treated as a partnership unless it elects to be taxed as an association (i.e., as a corporation). And under Code Sec. 1372 , for fringe-benefit purposes, more-than-2% S corporation shareholder-employees are subject to the rules that apply to partners, and S corporations are treated as partnerships. As a result, unless otherwise noted, the tax consequences of fringes for members of LLCs taxed as partnerships and for more-than-2% S shareholder-employees are the same as they are for partners.
Working condition fringe benefits. Property or services supplied by an employer to an employee are tax-free working condition fringe benefits (WCFBs) if the employee would be entitled to a business expense deduction under Code Sec. 162 or Code Sec. 167 for the item had he paid for it himself. (Reg. § 1.132-5(a)(1)(i)) For WCFB purposes, the term “employee” includes partners who perform services for the partnership. (Reg. § 1.132-1(b)(2)(ii)) Thus, partners may receive the following WCFBs tax-free:
- Business-related use of a company auto, if properly substantiated. (Reg. § 1.132-5(a)(1)) The personal-use value of the auto must, however, be treated as compensation income. (Reg. § 1.61-21(a)(1))
- The business-use portion of company paid country club dues, even though the dues are completely nondeductible. (Reg. § 1.132-5(s))
- Job-related education expenses paid by the firm. (Reg. § 1.132-1(f))
- Job placement assistance. (Rev Rul 92-69, 1992-2 CB 51)
De minimis fringe benefits. For purposes of the tax-free de minimis fringe benefit rules, “employees” include any recipient of a fringe benefit. (Reg. § 1.132-1(b)(4)) So partners are entitled to get tax-free supper or supper money or local transportation fare if provided on an occasional basis in connection with overtime work. (Reg. § 1.132-6(d)(2)(i)) Other de minimis fringes include:
- traditional birthday or holiday gifts of property (not cash) with a low fair market value (an undefined term in the regs), occasional theater or sporting event tickets, and fruit, books, or similar property provided under special circumstances (e.g., on account of illness, outstanding performance, or family crisis) (Reg. § 1.132-6(e)); and
- traditional awards (such as a gold watch) upon retirement after lengthy service. (H Rept No. 99-426 (PL 99-514) p. 105)
Dependent care assistance. Partners are eligible for the Code Sec. 129 dependent care assistance exclusion. (Code Sec. 129(e)(3)) The exclusion is for amounts provided under a written plan of the employer and is limited annually to $5,000 ($2,500 for a married person filing separately). However, for a plan to qualify as a dependent care assistance program, no more than 25% of the amounts paid or incurred by the employer for dependent care assistance during the year may be provided for the class of individuals who are shareholders or owners (or their spouses or dependents), each of whom (on any day of the year) owns more than 5% of the stock or of the capital or profit interest in the employer. (Code Sec. 129(d)(4))
Educational assistance programs. Under Code Sec. 127, employers can set up educational assistance programs under which employees can receive up to $5,250 per year of graduate- or undergraduate-level educational assistance tax-free, whether or not job-related. Employees for this purpose include partners who have earned income from their partnerships, which, in turn, are treated as employers of these partners. (Code Sec. 127(c)(2); Code Sec. 127(c)(3); Code Sec. 401(c)(1)) However, no more than 5% of the cost of annual benefits may be provided for the class of individuals (and their spouses and dependents) each of whom (on any day of the year) own more than 5% of the stock or of the capital or profits interest in the employer. (Code Sec. 127(b)(1))
Athletic facilities. The Code Sec. 132(j)(4) exclusion for on-premises athletic facilities (e.g., swimming pool, gym) is available to partners (and their spouses and/or children). (Reg. § 1.132-1(b)(3))
No-additional-cost services and qualified employee discounts. For purposes of these tax-free fringes, partners who perform services for a partnership are treated as employed by the partnership. (Reg. § 1.132-1(b)(1))
Transportation fringes. A partner cannot exclude qualified transportation fringes under Code Sec. 132(f) (currently, the value of qualified parking up to $200 a month, and up to $115 a month of the combined value of transit passes and transportation in a commuter highway vehicle). (Code Sec. 132(f)(5)(E); (Reg. § 1.132-9(b), Q&A 24(a)) However, under the de minimis benefit rules, tokens or fare cards provided by a partnership to a partner that enable the recipient to commute on a public transit system (not including privately-operated van pools) are excludable from income if the value of the tokens or farecards in any month doesn’t exceed $21. If the full value of a pass provided in a month exceeds $21, the full value of the benefit is includible. (Reg. § 1.132-9(b), Q&A 24(b)) In addition, if a partner would be able to deduct the cost of parking as a business expense (e.g., parking cost incurred in connection with traveling from the regular office to another business office), the value of the free or reduced-cost parking is excludable as a working condition fringe benefit.