by George Delta, Esq., Advisor to IMA

Editor’s Note: This memorandum provides a brief overview of the federal income tax treatment of employee awards. It’s good information to have when you are selling employee recognition programs to your clients. January 2000.

Section 274(j) of the Internal Revenue Code, enacted by the Tax Reform Act of 1986, provides, in general, that an employer may deduct the cost of employee achievement awards given to the same employee up to $400.00 in any year. If the incentive awards are employee achievement awards made under one or established written plans or programs of the employer, the $400 deduction limitation is increased to $1,600.00 per employee.

Under Code section 74(c), however, the same awards are not included in the income of the employee. In addition to being excluded from the employee’s taxable income, the employee achievement awards are also excludable for employment tax purposes as well as from the social security benefit base. The employer must report on the employee’s form W-2 as wages or compensation any portion of the employee achievement awards that is included in the employee’s income. This amount is also treated accordingly for all other tax purposes (including social security tax).

In order to qualify for this favorable tax treatment, an incentive award must be an “employee achievement award,” that is, it must be an item of “tangible personal property” transferred by an employer to an employee for safety achievement or length of service. Moreover, the award must be given as part of a meaningful presentation and cannot be the payment of disguised compensation to the employee. Thus, for example, an incentive award will not qualify for favorable tax treatment if it is given at the same time that annual salary adjustments are made, or if it’s used as a substitute for a program of awarding cash bonuses. Code section 274(j)(3)(A).

There is very little guidance issued by the Internal Revenue Service ("IRS") on employee achievement (incentive) awards. In the absence of such authority, taxpayers have had to rely on the General Explanation of the Tax Reform Act of 1986, Joint Committee on Taxation (JCS-10-87), commonly referred to as the “Blue Book,” and regulations proposed by the IRS on January 9, 1989. These regulations, Prop. Treas. Reg. Section 1.274-8 have not been finalized and are not binding on taxpayers; however, they do provide some insight as to the thinking of the IRS in this area.

The old regulations in effect before the enactment of Code section 274(j), Treas. Reg. Section 1.274-2(d)(1), defined an achievement award as an item of “tangible personal property” given to an employee for length of service, productivity, or safety achievement. New Code section 274(j) does not include awards for productivity in the definition of employee achievement awards. Thus, apparently, an incentive award can be given to employees for safety achievement or length of service only. According to the Blue Book, an award given to an employee for any other purpose, such as exceptional productivity, cannot be excluded from his income. Blue Book at 35, n.14. In view of the change in the law, employers have emphasized incentive awards rewarding length of service and safety achievement and have avoided productivity awards.

The requirement that an employee achievement award must be an item of “tangible personal property” has caused some confusion, because Code section 274(j) does not define the meaning of that term. The proposed regulations do provide some insight into the meaning of “tangible personal property” by defining it to exclude certain items. Accordingly, an incentive award cannot be in the form of cash or a gift certificate (other than a non-negotiable certificate conferring only the right to receive tangible personal property). Any certificate that may be converted to cash is not “tangible personal property” and cannot qualify for preferential tax treatment under Code section 274(j). Other items that are not tangible personal property include travel, vacations, meals, lodging, tickets to theater or sporting events, and stocks, bonds, or other securities. Prop. Treas. Reg. Section 1.274-8(c)(2). As a result, the fair market value of incentive travel awards given to employees is always taxable as additional income to them and deductible by the employer as compensation paid. Many employers, therefore, reimburse employees for the additional tax due as a result of the incentive travel award.

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