In previous articles we’ve covered virtually every component related to designing, developing, launching, and running an incentive program. We’ve talked about how and why incentive programs work, the various kinds of programs you might consider implementing, how to work with a bank, the ins and outs of web portals, the advantages of partnering with an outside firm, and what it costs to run an incentive program.
At this point, you might think that you’re ready to launch your first program. But we’d be remiss not to mention one very important (and sometimes boring) consideration: The tax implications of an incentive program.
The realization that your incentive program could create unknown tax implications can hit you like a ton of bricks. Is this a whole can of worms that you’re about to open? How much trouble is this going to be? What is this going to cost you in terms of additional accounting expenses (not to mention overall headache)? Is this whole incentive thing really worth it if you’re going to have to deal with a mountain of tax paperwork?
If these and other similar thoughts are running through your head, we don’t blame you. But let us assure you, the tax implications of an incentive program don’t have to be as complicated or painful as you might think. In this article, we’re going to look at how incentive rewards are treated from a tax perspective, including how you’ll need to account for them when it comes to employees, outside salespeople, and customers. We’ll also discuss the question of whether points are actually worth something, and how to account for them when doing your books.
Before we continue, though, we should mention an important disclaimer. This article is not intended to serve as professional tax or accounting advice. While we’re proud of the fact that our firm brings a lot of experience to the table when it comes to incentives, we’re not licensed to provide accounting or tax advice. So, at the end of the day, it’s important to consult with your accounting and/or tax professional when it comes to specific questions surrounding your individual organization’s unique situation.
With that important disclaimer behind us, let’s plunge ahead!
Incentives, Rewards, Cash, and Taxes
We’re accustomed to thinking of tax liability as something that accompanies cash compensation. If you pay someone for services rendered, that payment has to be accounted for when it comes time to file taxes in the US. Everyone knows this, and it’s a pretty straightforward principle. Are you paying someone an hourly wage? You’ll need to issue them a W-2 at the end of the year. Did someone perform a one-time contractual service for your company? If so, they’ll probably need a 1099-MISC form (we’ll discuss 1099-MISC forms in greater detail below). Either way, this is something your organization is (hopefully!) already accustomed to doing.
But what about when it comes to a bonus check? Does that still count as compensation? If so, does it need to be included on an employee’s W-2 form? What if instead of a bonus check, you issue them a prepaid reloadable debit card? Does that change the situation? Or, what if instead of paying your employee with cash in one form or another, you compensate them for a job well done with some sort of tangible reward—maybe a vacation, a top-of-the-line flat screen TV, or a gas card? For that matter, what happens if, instead of simply offering these rewards to your employees directly, you reward them with points which can then be exchanged for these and other items?
As it turns out, various bonuses, rewards, and points are accounted for according to specific rules laid out by the IRS in IRS Publication 525, Taxable and Nontaxable Income. Below, we’ll look at what IRS Publication 525 has to say about how to account for compensation related to incentive programs, both for employees and external salespeople.
Incentive Rewards and Employee Tax Liability
When it comes to your organization’s employees, IRS Publication 525 specifically addresses bonuses, awards, and employee achievement award compensation.
According to Publication 525, page 3:
“Bonuses or awards you receive for outstanding work are included in your income and should be shown on your Form W-2. These include prizes such as vacation trips for meeting sales goals. If the prize or award you receive is goods or services, you must include the fair market value of the goods or services in your income. However, if your employer merely promises to pay you a bonus or award at some future time, it isn’t taxable until you receive it, or it is made available to you.”
Note that this applies to awards received “for outstanding work.” This means that you’ll have to account for incentive rewards given to employees if those rewards are the direct result of work that the employee has performed. In these instances, you’ll need to include this compensation on the employee’s W-2 form. When the compensation takes the form of goods or services rather than actual cash, you’ll need to compute the value of those goods or services and add them to the W-2 form.
However, certain employee achievement awards are treated differently. According to Publication 525, page 3:
“If you receive tangible personal property (other than cash, a gift certificate, or an equivalent item) as an award for length of service or safety achievement, you generally can exclude its value from your income. However, the amount you can exclude is limited to your employer’s cost and can’t be more than $1,600 ($400 for awards that aren’t qualified plan awards) for all such awards you receive during the year. Your employer can tell you whether your award is a qualified plan award. Your employer must make the award as part of a meaningful presentation, under conditions and circumstances that don’t create a significant likelihood of it being disguised pay.
However, the exclusion doesn’t apply to the following awards:
A length-of-service award if you received it for less than 5 years of service or if you received another length-of-service award during the year or the previous 4 years.
A safety achievement award if you are a manager, administrator, clerical employee, or other professional employee or if more than 10% of eligible employees previously received safety achievement awards during the year.”
As you can see, there’s a difference between incentive rewards earned for something like sales performance on the one hand and a small length-of-service gift on the other. The IRS also gives a fairly straightforward and specific example here of how these smaller length-of-service gifts are calculated. If a hypothetical employee receives a total of three length of service gifts—say, a $250 watch, a $1,000 stereo, and a $500 set of golf clubs—that employee is tax liable for those gifts insofar as they exceed the above specified amount of $1,600. In this case, $250 + $1,000 + $500 = $1,750, and $1,750 – $1,600 = $150. So, you would be responsible for accounting for an extra $150 in employee compensation on this employee’s W-2 form, and the employee would be responsible for paying taxes on that additional $150.
Incentives and Non-Employees
The above rules are laid out by the IRS with respect to employees who are on your payroll. If you compensate an employee for work performed via the use of an incentive reward, you’re expected to include that reward as compensation on the employee’s W-2.
But what about non-employees? As we discussed earlier in this article, incentive programs can be especially effective when it comes to changing the behavior of third-party salespeople working for independent dealers—people who aren’t on your payroll. If you provide these independent sales reps with incentive rewards, do you have to account for those rewards from a tax perspective? And if so, how do you go about doing it?
If your US-based company has enlisted the services of independent contractors in the past, you’re likely already familiar with 1099 forms. If you’re not familiar, though, 1099 forms are a series of forms available from the IRS that are used to file an information return in order to account for income not derived from direct employment. The most common 1099 form that you’ll likely encounter is the 1099-MISC, which is generally used to account for payments made to independent contractors.
So, let’s say you’re issuing a reward of some kind to an external salesperson as part of an incentive program you’re running in connection with independent dealers. There’s one simple question you’ll need to ask yourself here: Did this person do some form of work (other than making a purchase, for example, as would be the case with a customer receiving a rebate) in order to achieve the reward in question? If the answer to this question is “yes,” then you’ll more than likely need to issue that person a 1099 form.
Keep in mind that there’s one exception to this rule. A 1099-MISC form only has to be filed if the third-party salesperson in question received a total of $600 USD or more in a given calendar year. So, if your incentive reward program involves issuing small rewards to a large number of salespeople, you’re less likely to end up in a scenario where you’re having to file a large number of 1099 forms. (Companies outside of the US should consult their tax professional on the rules for non-employee reward taxation.)
It’s not uncommon to run into people in the incentive industry who will tell you that this isn’t important or isn’t something to worry about. But we’re here to tell you, this isn’t something you can ignore. The law is the law. And if you’re running a large incentive program that involves thousands upon thousands of dollars in payments, failing to properly account for all of those expenses (and for all of the income associated with them for the people receiving them) may cause you major problems down the road.
When it comes to adding reward totals as compensation to employee W-2 forms, your accounting department or external accountant will likely be able to handle this without a lot of extra hassle. But when you’re dealing with external sales reps, things are a bit more complicated. You’ll need to collect the Social Security number of each person in order to issue them a 1099, and it’s obviously important to treat this data with care. One of the easiest ways to handle this is with a secure online form that’s built into your web portal, accompanied by the proper opt-in language to ensure that the recipient in question understands what data they’re providing to you and why. This form can essentially serve as a virtual W-9 form and even include the requisite language from the W-9. (Some CPA’s believe a paper W-9 is required, although we don’t personally subscribe to this belief, given that paper forms are far less secure than digitally protected forms).
In our experience, it’s generally best to let the outside incentive firm you’re working with handle the entire 1099 process. This is especially true if you’re dealing with a massive number of 1099s. Of course, if you work in a field such as accounting and already have a ton of experience dealing with something like this, then that may change your situation somewhat. But for the most part, we’ve found that it’s typically easier for companies to simply outsource this work to their incentive partner.
While you may not be handling the filing of 1099s on your own, it’s worth pointing out that the 1099-MISC form actually includes two separate boxes where compensation can be accounted for: Box 3, “Other Income,” and Box 7, “Nonemployee Compensation.” According to the IRS’s Instructions for Form 1099-MISC, the difference in these seemingly similar boxes is that Box 3 is for prizes and awards unrelated to services performed, whereas Box 7 would include compensation in exchange for the performance of actual services. Typically, we recommend putting the value from winning random drawings in Box 3, and anything else explicitly earned goes into Box 7. The advantage to Box 3 is a slightly lower tax burden for most filers. Keep this in mind if attempting to fill out a 1099 on your own.
Additionally, you’ll need to file something with the IRS known as a 1096 form. This serves as kind of master informational tax form. It’s used to summarize all of the 1099s that you’re issuing to other individuals. In other words, the 1096 form won’t be sent to any reward recipients or third-party salespeople—it’s only sent to the IRS for informational purposes. Typically, a copy of the 1096 is sent to our partners’ payroll and/or tax departments so they have an official record.
Are Points Worth Something?
At this point, we’ve looked at how to account for rewards issued to employees and non-employees. By accounting for incentive rewards properly, you’ll ensure that you’re in compliance with tax law and IRS requirements.
There’s one more issue to tackle here, though—the notion of points.
Maybe the thought hadn’t occurred to you up until now but take a moment to ask yourself what points are exactly. How should you handle them? If you’re issuing points to your employees that can be exchanged for merchandise or prepaid debit cards, do those points then count as a form of cash compensation? And if so, how do you account for them?
Believe it or not, the IRS actually specifically addresses the issue of “prize points” in Publication 525. On page 32 of Publication 525, the IRS outlines exactly how points should be accounted for:
“If you are a salesperson and receive prize points redeemable for merchandise that are awarded by a distributor or manufacturer to employees of dealers, you must include their fair market value in your income. The prize points are taxable in the year they are paid or made available to you, rather than in the year you redeem them for merchandise.”
In other words, points do indeed count as a form of compensation, and they do have to be included as income when tax time rolls around.
We’ll be honest with you here: We’ve seen 99% of companies choose to ignore this rule. But that doesn’t mean that ignoring it is the right thing (or the legal thing) to do. Technically speaking, points should be included in your accounting. They’re on the books. And the IRS expects them to be accounted for from a tax perspective, too.
Now, if the prize points are redeemed for something in a given calendar year, then you’ll simply follow the guidelines provided above as they relate to the inclusion of the fair market value of various prizes, travel awards, and so on. But what if someone doesn’t use all of their points in a given year? That’s when they become taxable in and of themselves. The fair market value of the points themselves will then need to be accounted for.
Assuming you and your tax advisors have a risk-adverse viewpoint surrounding this rule, and you want to follow it to the letter of the law, what’s the best way to handle this from a practical perspective? To simplify things as much as possible, we advise our clients to do something that we call a “year-end cash out” of points. Essentially, this is where you automatically disperse the value of any accumulated points on a given date at the end of the year. It can be a good idea to notify program participants that their points will be cashed out automatically if they’re not redeemed, and to encourage them to go ahead and redeem their points before that happens. If the deadline rolls around and someone has leftover points, though, you simply load a prepaid debit card with the corresponding cash value of the points and issue it to the recipient in question. This keeps you in compliance with the requirements laid out by the IRS and ensures that things add up from an accounting perspective at the end of the year. And it’s far kinder than taxing a third-party rep on the value of abstract points.
Rebates and Taxes
What about customer rebates? What are the tax considerations with those? Here’s some good news, and we’ll keep it simple. The IRS doesn’t require any tax reporting for the purposes of issuing customer rebates. So rest easy.
Incentive Rewards and Our Own Taxes
How does running an incentive program affect your own tax liability as a company? Well, it’s generally possible to write off the various costs associated with running an incentive program as a business expense. This doesn’t just include the fees paid out to an external firm, the cost of setting up and maintaining a web portal, and so on. In addition, this means that you ought to be able to deduct the costs associated with issuing the reward funding itself. In other words, these tax liable rewards that you’re issuing to others can be deducted from your annual gross revenue in determining your company’s own tax liability. As we mentioned in an earlier article, incentive programs are often expensed as a marketing cost; however, it’s worth giving some consideration to how you want to treat rewards from a cost center perspective.
We’re not tax experts or accountants, and we don’t claim to have all of the answers when it comes to your particular organization’s unique scenario and needs. We highly recommend that you contact an accountant or tax professional when it comes to ensuring that you’re properly accounting for your incentive program.
So, that’s it! From an accounting perspective, we’ve addressed a lot of major questions here. But there’s one last practicality to consider when it comes to working with third-party dealers. When you go to actually issue the payment of rewards to external salespeople, do you issue those rewards to each individual salesperson directly? Or, do you pay out those incentives to the franchise owner or dealer principal, allowing them to then distribute the rewards on their own? As it turns out, the answer to this question can have a major impact on the success (or failure) of your incentive program.