QUESTION: If employees don’t have to pay federal income tax on a fringe benefit because the benefit isn’t treated as income under the Code, does that mean they don’t have to pay FICA taxes on it either?
ANSWER: Not always. Though it may seem like that should be true—either both income and FICA taxes should apply, or neither should apply, it isn’t quite that simple. While fringe benefits that are excluded from income for federal income tax purposes are usually exempt from the taxes funding Social Security and Medicare (collectively, FICA taxes), this is not always the case. (The same is true for federal unemployment tax (FUTA) and railroad retirement tax (RRTA).) Adoption assistance benefits are one example—the Code excludes amounts paid by an employer for qualified adoption expenses under an adoption assistance program from an employee’s income, subject to the applicable dollar and income limits, but those amounts are still subject to FICA taxes. Pre-tax contributions to 401(k) plans are another well-known example in the retirement plan context.
To understand why the rules for federal income and FICA taxes don’t always operate in sync, it helps to remember that all fringe benefits are subject to both federal income and FICA taxes unless the Code provides a specific exclusion, and that each tax has its own exclusions. For example, benefits under a qualified transportation plan are not subject to federal income tax because they are excluded from gross income under Code § 132, and they are not subject to FICA taxes because a different Code section (Code § 3121) excludes them from “wages,” and FICA taxes only apply to wages within the meaning of that definition.
In the case of adoption assistance benefits, Code § 137 allows qualified benefits to be excluded from gross income, so they are not subject to federal income tax. But the Code § 3121 definition of wages for FICA purposes has no corresponding exclusion. Interestingly, the separate definition of wages for purposes of income tax withholding in Code § 3401 also fails to exclude amounts paid under a qualified adoption assistance program, but the IRS has issued guidance waiving the income tax withholding requirement for these payments. It is worth noting that the absence of a FICA tax exclusion for adoption assistance makes it somewhat less attractive to employers and employees (each of whom pays a portion of the FICA tax).
Keeping in mind that state and local income tax laws may differ from the federal income tax rules, employers should check all applicable laws to fully understand their tax withholding obligations for each fringe benefit.
For more information, see EBIA’s Fringe Benefits manual at Sections II (“Tax Basics for Fringe Benefits”) and III (“Qualified Adoption Assistance Programs”).
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