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Use salary reduction plan to lower tax

by on
in Small Business Tax,Small Business Tax Deduction Strategies

Suppose your employees regularly incur business expenses that are not reimbursed by your company. For example, they might personally pay for business travel or tools.

If that’s the case, there’s a way you can save income tax for employees while cutting employment tax for your company.

Strategy: Set up a salary reduction plan. Arrange to set aside a small portion of the employees’ salaries. Then you can use this money to reimburse the employees for the expenses.

The plan must be mandatory for the employees to realize tax benefits. They aren’t permitted to have a choice in the matter. For instance, you can’t let employees decide between having their salaries cut and paying their own expenses.

Employees don’t have to report the reimbursements as taxable income. And, because of the way that business expenses are deducted on a personal tax return, it’s likely that your employees will come out ahead of the game.

Reason: Unreimbursed employee business expenses are deducted as miscellaneous itemized deductions subject to the 2%-of-AGI limit. Therefore, many taxpayers get little or no tax benefit from these expenses. A salary reduction plan removes the limitation and effectively allows an employee to deduct 100% of the expenses.

Note that highly paid employees who have to pay the alternative minimum tax (AMT) may also benefit from a salary reduction plan. That’s because unreimbursed employee business expenses aren’t deductible under the AMT calculation. A salary reduction program reduces AMT exposure.

For its part, your company is relieved of employment tax liability through a salary reduction arrangement. Yet it still can deduct the reimbursements as business expenses.

But there’s a downside. A system like this means more paperwork. You have to track the amount of each salary reduction, account for employee business expense claims and make the reimbursements.

Tip: Before you set up a salary reduction plan, make sure the company’s tax savings are greater than the cost of the extra bookkeeping.

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