Employee fringe benefits generally consist of property or services provided directly or indirectly to or for an employee as a salary or wage supplement. One of the advantages of a C corporation is that it permits an owner/employee of the business to participate in certain fringe benefits provided for employees and receive the same favorable tax benefits. The value of many of these benefits is excluded from the employee’s income by specific statutory provisions but the corporation is entitled to deduct the cost.
Two major questions related to this subject are:
- What are fringe benefits?
- How do partnerships treat fringe benefits?
There is no inclusive definition of “employee fringe benefit” for partnership. Subchapter K of the Internal Revenue Code, dealing with the tax treatment of partners and partnerships, contains no direct reference to “employee fringe benefits.” The general rule is that partners do not qualify for the exclusions afforded certain employee fringe benefits due to the absence of an employer-employee relationship. Absent an official definition of a fringe benefit in the partnership provisions, other sections of the Code must be examined to arrive at a definition of “employee fringe benefits.” Such an examination reveals that although there is no statutory definition, the legislative history of Code Sec. 1372 does list five employee benefits that
Congress considers to be fringe benefits.
- The former $5,000 death benefit exclusion set forth in former Code Sec. 101(b).
- The exclusion from income of amounts received by the taxpayer from an accident and health plan as set forth in Code Sec. 105(b), (c) and (d). 191
- The exclusion from income of amounts paid by an employer to an accident and health plan as provided in Code Sec. 106.
- The exclusion of the cost of up to $50,000 in group term life insurance on an employee’s life provided by Code Sec. 79. 192
- The exclusion from income of meals or lodging furnished for the convenience of the employer set forth in Code Sec. 119.
Tax-Free Fringes
When the fringe benefits listed are provided by the partnership or LLC to a partner or member in exchange for services, the benefits qualify for tax-favored treatment. This means the company can deduct the costs of providing these benefits and they are tax free to the recipient for federal income tax purposes. These employee benefits include:
- Group legal services plans.
- Pension and profit-sharing plans (Sec. 401(c)(1));
- Compensation for injury or sickness (Sec. 104(a)(3));
- Employer-provided educational assistance (sec. 127). The partnership can pay job-related education expenses for the partner and deduct the cost without the partner recognizing income; this is slightly different from educational assistance programs (which can be used for job-related or unrelated education)
- Child and dependent care assistance (sec 129) . (Provided that no more than 25% of the amounts paid annually are paid to 5% owners of the partnership)
- No-additional-cost services.
- Qualified employee discounts.
- Working conditions fringe benefits.
- De minimis fringe benefits.
- On-premises athletic facilities.
- Qualified retirement plans.
Fringes Treated as Taxable Guaranteed Payments
The cost of providing the following fringes to a partner or LLC member in exchange for services are treated as deductible guaranteed payments made by the entity and taxable income from guaranteed payments under Code Sec. 707(c).
- Group term life insurance coverage of up to $50,000 (Sec. 79);.
- Amounts received from accident and health plans (Sec. 105);
- Contributions by an employer to accident and health plans (Sec. 106);
- Premiums for accident and health insurance coverage for the partners and members, their spouses, and dependents.
- Meals and lodging furnished for the convenience of the employer (Sec. 119);
- Employee achievement awards (Sec. 74(c)
- Cafeteria plans (Sec. 125);
- Qualified transportation fringe benefits (Sec. 132(f));
- Adoption assistance programs (Sec. 137(c)(2));
- Contributions by the corporation to health savings accounts (Sec. 223); and
- Qualified moving expense reimbursements (Sec. 132(g)).
Each partner or LLC member can generally deduct 100 percent of his or her company-paid health insurance premiums on page 1 of Form 1040. (Sources: IRS Revenue Ruling 91-26 and IRC Section 162(l). However, the partner or LLC member is not entitled to any personal deductions for the other company-paid fringes listed above.
Sec. 1372(a) states that for fringe benefit purposes, an S corporation “shall be treated as a partnership” and a 2% shareholder “shall be treated as a partner of such partnership.” A 2% shareholder is one that owns more than 2% of the corporation’s outstanding stock on any day during the S corporation’s tax year, considering direct and constructive ownership (Secs. 1372(a) and (b)).
A special set of federal income tax rules applies to fringe benefits provided by a partnership to its partners in exchange for their services to the business. The same set of rules also generally applies to multi-member LLCs (meaning LLCs with more than one owner), because they are generally treated as partnerships for federal tax purposes.
With this background in mind, here is a brief summary of the tax treatment of fringe benefits provided by your partnership to its partners or your LLC to its members.
Fringes Treated as Taxable Guaranteed Payments
The cost of providing the following fringes to a partner or LLC member in exchange for services are treated as deductible guaranteed payments made by the entity and taxable income from guaranteed payments for the recipient:
- Premiums for accident and health insurance coverage for the partners and members, their spouses, and dependents.
- Group term life insurance coverage of up to $50,000.
- Disability insurance coverage.
- Meals or lodging furnished for the convenience of the partnership or LLC as the employer (for this purpose, partners or LLC members are considered employees).
- Cafeteria benefit plan.
- Qualified transportation fringes.
- Qualified adoption assistance program.
Each partner or LLC member can generally deduct 100 percent of his or her company-paid health insurance premiums on page 1 of Form 1040. (Sources: IRS Revenue Ruling 91-26 and IRC Section 162(l) However, the partner or LLC member is not entitled to any personal deductions for the other company-paid fringes listed above.
Tax-Free Fringes
When the fringe benefits listed are provided by the partnership or LLC to a partner or member in exchange for services, the benefits qualify for tax-favored treatment. This means the company can deduct the costs of providing these benefits and they are tax free to the recipient for federal income tax purposes (
Other Benefits
If your partnership or LLC provides fringe benefits not specifically mentioned in this article, (for example, season tickets to sporting events), the cost is generally considered a guaranteed payment to the recipient partner or LLC member. As such, the cost is deducted by the partnership and reported as taxable income by the recipient.
It’s also important to understand the special rules for partners and LLC members don’t affect the tax treatment of fringes provided to rank-and-file employees. Typically, it’s easier to provide perks to these workers on a tax-free basis assuming the basic qualification rules are met):
- Qualified educational assistance program.
- Qualified dependent care assistance program.
- No‑additional‑cost services. For example, an airline might allow its employees to fly in empty seats without paying for tickets.
- Qualified employee discounts (for this purpose, partners or LLC members are treated as employees).
- Working condition fringe benefits, such as meals provided for the convenience of the company.
- De minimis fringe benefits such as the personal use of a company copy machine and small, non-cash gifts.
- On‑premises athletic facilities.
The Cafeteria Plan Problem
Here’s where many firms stumble catastrophically. Partners cannot participate in cafeteria plans (Section 125 plans). Period. Full stop. No exceptions.
Why does this matter? Because if even one partner participates in your cafeteria plan:
- The entire plan could be disqualified
- All employees lose their pre-tax benefits
- Everyone’s benefits become taxable retroactively
- You face a compliance nightmare reaching back to the oldest open tax year
We’ve seen firms discover this violation years after the fact. One firm had three partners participating in their FSA for two years. The fix required:
- Amending partnership returns for both years
- Amending all three partners’ personal returns
- Recalculating and paying additional self-employment taxes
- Filing corrected W-2s for all employees (to fix the cafeteria plan)
- Paying penalties and interest on late tax payments
Retirement Contributions for partner
Retirement planning for partners involves a maze of rules that differ significantly from employee 401(k) participation. Let’s break down what you need to know.
The Earned Income Calculation
For partners, retirement plan contributions are based on “earned income” from self-employment, not W-2 wages. This calculation is more complex than it appears:
Earned Income = Net Self-Employment Income – (1/2 Self-Employment Tax) – Retirement Contributions
This creates a circular calculation because the contribution amount affects the earned income, which affects the allowable contribution. Most firms use software to handle this calculation, but understanding the concept is crucial.
Contribution Limits and Options
401(k) Plans For 2024, partners can contribute:
- Employee deferrals: $22,500 (plus $7,500 catch-up if 50+)
- Employer contributions: Up to 25% of earned income
- Combined maximum: $66,000 ($73,000 with catch-up)
But here’s the catch: the “employer” contribution is really coming from the partner’s share of profits. It’s not an additional firm expense like it is for employees.
SEP-IRA Plans Simpler but less flexible:
- Contribution limit: Lesser of 25% of earned income or $66,000
- Must contribute the same percentage for all eligible participants
- No catch-up contributions
- No Roth option
Cash Balance Plans For highly profitable firms, adding a cash balance plan can dramatically increase retirement savings:
- Can contribute $200,000+ annually for older partners
- Requires actuarial calculations and higher administrative costs
- Must cover most employees, making it expensive for firms with many non-partner employees
The K-1 Reporting Dance
Retirement contributions for partners Retirement plan contributions made for a partner are not deducted on the partnership’s tax return. they are reported on K-1 reporting that trips up even experienced administrators:
- Firm contributions appear on K-1, Box 13, Code R
- Partners report these on Schedule 1, Line 16
- The contribution reduces the partner’s taxable income but not self-employment income
- Partners must track their basis to avoid issues with distributions