The tax reform package signed into law late last year included a provision eliminating the ability of employers to deduct payments made for qualified transportation benefits like employee parking and mass transit passes. The new rule is straightforward when the employer reimburses employees for their transportation expenses – the employer’s reimbursement is not deductible. Until recently, the rule was less clear when employees pay transit expenses through pretax salary reductions. Subsequent IRS guidance has clarified that employee salary reduction contributions to pay for transportation expenses are not deductible.
Lockton comment: Employer-sponsored salary reduction programs to pay for transportation expenses are a popular benefit to help employees defray the cost of traveling to and from work. In fact, several larger cities and metropolitan areas, like New York City, San Francisco and the District of Columbia, have laws requiring employers to sponsor plans allowing employees to make pretax salary reductions to pay for transportation expenses.
Just like before tax reform, the employer and employee continue to reap the payroll tax savings on the salary reduction amount up to the transportation benefit limits. The employee also continues to escape income taxes on the salary reduction amount.
Example: Westport pays Karen $50,000 in wages. The following chart compares the tax consequences of Karen taking the entire $50,000 in taxable wages versus making a $2,000 pretax salary reduction to pay for qualified transportation expenses (assuming no other exclusions, deductions or credits):
| No salary reduction | Salary reduction for qualified transportation expenses | Result | |
|---|---|---|---|
| Westport’s wage deduction | $50,000 | $48,000 | Westport will pay taxes on an additional $2,000 as a result of losing the deduction for the salary reduction. Assuming a 21 percent corporate income tax rate, this means the lost deduction costs $420 in corporate income taxes. |
| Westport’s payroll tax liability (at 7.65 percent)* | $3,825 | $3,672 | Westport saves $153 in payroll taxes with the salary reduction program. |
| Karen’s income tax liability (at 22 percent)* | $11,000 | $10,560 | Karen’s salary reduction results in her saving $440 in personal income taxes. |
| Karen’s payroll tax liability (at 7.56 percent)* | $3,825 | $3,672 | Karen saves $153 in payroll taxes with the salary reduction program. |
*The payroll tax and personal income tax consequences did not change because of tax reform.
Because of the lost deduction, the net effect of Karen’s salary reductions compared to paying taxable salary is $267 in additional taxes for Westport and $593 less in taxes for Karen.
The IRS’s interpretation may be particularly impactful for tax-exempt entities. Tax-exempt entities usually do not need to consider deductions because their income already escapes taxation. The new tax law, however, tries to level the playing field between taxable and nontaxable entities by subjecting tax-exempt entities to unrelated business income tax (UBIT) on employer-paid transportation benefits. The IRS’s interpretation means tax-exempt entities will need to include both employer reimbursements and pretax salary reductions in their UBIT calculation. That can result in a 21 percent tax on the amount of the benefits for affected tax-exempt entities.
Lockton comment: Only employers are affected by the lost deduction, not employees, so immediate changes to payroll are unnecessary. Employers will, of course, want to work with their tax advisors to determine how the change impacts their tax filings.