Taxable Income and Employee Compensation
Although a nonprofit organization, the university is required to file information returns with the Internal Revenue Service to report certain types of payments made during the year. Non-employee reporting is handled through the Controller's Office; employee reporting is handled by the Payroll Office.
Concept of Gross Income
Gross income is the starting point for determining the taxable income of any taxpayer. The definition of gross income under the federal tax laws is extremely broad and includes all items of value (in the form of money, property, or services) that a taxpayer receives from whatever source derived, unless a specific provision in the tax laws excludes the item from gross income.
University employees may receive funds in many forms, including wages, bonuses, service awards, scholastic awards, and honoraria, as well as non-monetary compensation, such as services or property. When considering whether a particular item is taxable, the IRS generally presumes that any payment from a university to an employee constitutes taxable compensation. To rebut that presumption, the employee must be able to point to a specific provision in the tax laws that expressly excludes the particular payment from gross income. Special provisions include judicial precedents, IRS Revenue Rulings, IRS Technical Advice Memoranda specific to the university, IRS Private Rulings, results of past audits, or longstanding, recognized industry practices.
Who Are Employees?
The Internal Revenue Service defines employees either under common law or under special statutes for certain situations.
Under common law, a worker who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.
People such as doctors, lawyers, contractors, subcontractors, and other workers who follow an independent trade, business, or profession in which they offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.
If an employer-employee relationship exists, it does not matter what it is called. The employee may be called an agent, consultant, or independent contractor. The substance of the relationship, not the label, governs the worker's status. It also does not matter how payments are measured or paid, what they are called, or if the employee works full or part time.
Employees cannot be treated as non-employees. Furthermore, organizations cannot make payments to non-employee workers if a substantially similar payment has been made to an employee since January 1, 1978. The university remains liable for social security and Medicare taxes even though these taxes were not deducted and withheld because an employee was treated as a non-employee.
Wages subject to federal employment taxes include all pay that you give to an employee for services performed. The pay may be in cash or in other forms. It does not matter how you measure or make the payments. Also, compensation paid to a former employee for services performed while still employed is wages subject to employment taxes.
If in the course of your operations you pay your employees in a medium that is neither cash nor a readily negotiable instrument, such as a check, you are said to pay them "in kind." Payments in kind may be in the form of goods, lodging, food, clothing, or services. Generally, the fair market value of such payments at the time that they are provided is subject to income tax withholding and social security, Medicare, and unemployment taxes.
Reporting Non-Cash Compensation
The department providing the goods or services to the affected employee is responsible for reporting the taxable transaction to the payroll office. Transactions originating on a Request For Disbursement form to the accounts payable office and goods/services acquired through a procard transaction will be reported to the payroll office on a Non-Cash Compensation Form. For current and future transactions, completed Non-Cash Compensation Forms must accompany each Request For Disbursement involving taxable goods and services. Accounts payable processing will not occur without the appropriate forms.
Because gross income generally includes all items of value received by an employee, when an employee receives a reimbursement from his or her employer for business expenses incurred such as airfare, meal, or lodging, the reimbursement payment technically constitutes gross income to the employee. A reimbursed employee business expense can be excluded from gross income, however, only if it is made pursuant to a reimbursement or expense allowance arrangement (known as an "accountable plan"), under which the employer requires the employee to substantiate all expenses and repay any amounts received in excess of the substantiated expenses.
In order to qualify as an "accountable plan," the following tests must be met: (1) reimbursements can be made only for business expenses incurred by the employee in connection with the performance of the employee's duties; (2) the plan must require employees to substantiate their expenses within a reasonable period of time; and (3) the plan must require employees to repay any reimbursements that exceed substantiated expenses within a reasonable period of time. If these tests are not met, the full amount of the reimbursement is included in the employee's income.
Travel, Meal, and Entertainment Expenses
In order for an employee to be paid expenses for travel, meals, and entertainment as business expenses, the Internal Revenue Code requires that the employee maintain extensive substantiation. In general, a taxpayer must substantiate with contemporaneous records the following elements for each expenditure: (1) the amount of the expenditure; (2) the date, time, and place of the travel, meals, or entertainment; (3) the business purpose served by the expenditure; and (4) the business relationship to the taxpayer of each person entertained. If these requirements are not satisfied, the university can disallow the claimed expense in full.
In addition to the substantiation requirements, entertainment and travel expenses can be paid only under limited circumstances, and lavish or extravagant entertainment expenses cannot be paid. Moreover, entertainment expenses can be paid only if an employee is able to establish that the expenditure was directly related to, or associated with, the active conduct of his or her employment-related duties.
An entertainment expense is "directly related to" the active conduct of business if the employee actively engages in bona fide business discussions during the entertainment and does not provide the entertainment merely to create goodwill--in other words, the principal character of the combined business and entertainment activity must be the conducting of business. Accordingly, expense incurred in connection with certain entertainment events during which there is little or not possibility of engaging business discussions generally cannot be paid.
An entertainment expense is "associated with" the active conduct of business when the entertainment activity directly precedes or follows a substantial and bona fide business discussion. Entertainment that occurs on the same day as the business discussion is treated as directly preceding or following the discussion. In order to qualify, the principal character of the combined business and entertainment activity must be the active conduct of business, i.e., the business discussion must be substantial as compared to the entertainment activity.
The expense of a business meal, when the meal occurs under circumstances generally considered conducive to business discussion, are generally payable so long as the employee is present during the meal. Although such meal expenses must bear some rational relationship to business pursuits, they are not subject to the rigorous "directly related to" or "associated with" tests that are applied to entertainment expenses.