Non-taxable wages are wages given to an employee or individual without any taxes withheld (income, federal, state, etc.). However, most wages that you pay out to your employee(s) are taxable. So when are wages non-taxable?
The IRS definition of a non-taxable wage and other tax-exempt income is fairly narrow. (Please note that there are exceptions to the general guidelines so you will want to talk to your tax professional to be sure you are in compliance with the IRS.)
Non-taxable wages by category…
Gifts
Taxes on any gift are usually paid by the giver, not by the receiver. Any gift an employer gives out, therefore, is only taxable for the employer. Individuals can gift each other with a fairly large amount of money without paying taxes on it; however, employers are only allowed to give non-taxable gifts of up to $25. Any higher than that and the gift must be claimed.
Note that company bonuses and profit-sharing payments are not considered gifts and are, in fact, taxed at a higher amount than regular wages.
Disability wages
An employee who has been declared temporarily or permanently disabled may be eligible for disability pay. Disability wages generally fall under non-taxable income. However, if these disability payments come from an insurance policy where the premiums were paid by the employer, then the money will be taxed.
There are many disability payments that are not taxable. These include any payments from supplemental disability insurance paid for with after-tax money, private disability insurance, and worker’s compensation.
Also, any damages awarded that were compensatory (not punitive) due to injury, sickness, or loss of function are not taxable.
States without income tax
Obviously, any wage earned in one of the states that does not have a state income tax is considered a non-taxable wage as far as state taxes are concerned. However, this income is still taxed by the federal government. States where all wages are non-taxable (by the state) include Alaska, Nevada, Florida, Texas, Tennessee, South Dakota, New Hampshire, Wyoming, and Washington.
Is your business incorporated? Five states (Nevada, South Dakota, Texas, Washington, and Wyoming) offer corporations a break by not taxing corporate income. They are hoping to encourage businesses to locate in their states in an effort to boost the economy.
Partnership income
Partnership income is usually non-taxable. IRS 541 explains more about taxable wages with partnerships, and has a link to Form 1065 U.S. Return of Partnership Income.
Insurance provided by the employer
Any payments an employer makes towards an employee’s insurance (of any type) are not taxed because they’re not actually considered a part of the employee’s income. The same is true of any payment the employee makes towards their own health savings account. It doesn’t matter if the insurance is provided by a third party or through a health reimbursement arrangement—neither type of payment is taxable.
Other non-taxable income
The following situations may not occur in the course of doing business, but the IRS includes them with non-taxable income.
Life insurance payouts
Most life insurance policies that pay out to an individual due to someone’s death may not be taxed. However, this is not true if the policy is cashed in. In this case, any amount that the individual receives that is greater than the cost of the policy may be taxed. This only applies to policies that are paid out when the policy is redeemed for cash. Any policy that paid out due to death is a non-taxable amount.
Scholarship and financial aid
As an employer, if you provide educational assistance to an employee, the IRS says it is non-taxable up to $5,250 a year. These benefits should not be included on your employee’s Form W-2.
As a student, you may receive scholarships, financial aid, work/study job assignments, and other types of payments through a university while studying. This type of money is often non-taxable, but it depends on how the money is used. If it is used to pay tuition, fees, course materials, or textbooks, the money is not taxed. If, however, the money is used to pay for room and board or if it is paid directly to the student to use however they wish, then it is taxable income.
Welfare benefits
Any wages or type of income received through welfare programs are not taxed income. This includes food stamps and other assistance programs.
More categories of non-taxable income
Child support payments; gifts, bequests and inheritances; welfare benefits; damage awards for physical injury or sickness; cash rebates from a dealer or manufacturer for an item you buy; and reimbursements for qualified adoption expenses.
As always, be sure to check with your tax professional or accountant to determine which wages are non-taxable.
In the meantime, keep your payroll records accurate with online payroll software from Patriot Software.
This is not intended as legal advice; for more information, please click here.