The federal income tax considerations for incentive programs are often overlooked. While it is challenging to give technical tax advice that would apply equally to all incentive programs, the following income tax principles can make an incentive program more successful and avoid unpleasant surprises.
As a general rule, incentive prizes and awards given to individuals to reward them for sales, performance, learnings, or other work services provided are taxable as compensation regardless of whether the prize or award is in the form of cash, merchandise, or travel. Treas. Reg. § 1.74-1. Taxable compensation includes both cash and non-cash rewards because both are deemed earned for services rendered. Accordingly, prizes and awards are subject to income tax and payroll taxes. If the prize or award is merchandise or travel instead of cash, the item’s fair market value (FMV) must be included in income. The Internal Revenue Service (IRS) does not provide a clear value or formula; instead, it vaguely says FMV is based on all the facts and circumstances.
IRS Publication 525, Taxable and Nontaxable Income, states: 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 FMV of the goods or services in your income.
Carlson Marketing (now named One10) surveyed various merchandise items in its catalog, comparing those items’ prices to the prices for the same merchandise in different retail stores. After comparing store prices to the catalog point-list price, the survey concluded that a reasonable, fair market value would be 70% of the sales (point-list) price. The 30% discount reflected the marketing and fulfillment services that stores do not incur and do not have to pass through to their customers. These costs include: (1) the incentive design professional services to create the incentive program, (2) ongoing program management of the incentive program, (3) tracking and evaluating results for the incentive program, (4) merchandising services, (5) the fulfillment service for each order and its processing through a distribution center, and (6) website and technology software. “SHIAT” is a memorable acronym that describes other costs and services in the 30% discount for Shipping, Handling, Insurance, Administration, and (sales) Taxes. For example, if the point value of a HDTV used as an award in an incentive program is $1,000, its fair market value should be approximately $700.
The IRS created a special exemption from tax for qualified “employee achievement awards.” IRS Publication 525 states: 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 may generally exclude its value from your income. However, the amount you can exclude can’t be more than $1,600 for all such awards you receive during the year. 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.
Ignite is our flexible, graphically engaging, powerful platform built with you and your reps in mind. Behind the scenes of your incentive lies the backbone of its success. Ignite is Brightspot’s flexible SaaS software with quick setup and robust tracking & reporting to ensure you’re receiving the most accurate tax information.
Flexible modules accelerate launch – and new sales.
Out-of-the-box templates keep costs low.
In-house developers give you a roadmap for future growth.
Determining the fair market value of travel may prove to be somewhat more complex. In an effort to come up with some guidelines regarding the value of travel awards, Carlson Marketing studied its incentive travel costs as compared to those of outside travel agencies on selected trips, analyzed the cost of land travel (excluding airfare) for a single traveler compared to the cost of the same travel for each person who was part of a group, and reviewed group travel invoices to determine what components of cost should be included in the computation of fair market value. As a result of its analysis, Carlson concluded that a FMV of land travel would be 73% to 76% of land cost. Thus, as a general rule, a 25% discount should be acceptable. It also concluded that no discount was appropriate for air travel, although, presumably, the FMV of air travel would be determined by reference to discount travel fares. If the employer or the incentive company purchases the airfare, then the ticket’s purchase price should also be its FMV for income tax purposes. As with merchandise, the reasons for the discount of approximately 25% percent for land travel are that an individual would not incur certain costs: (1) there would be no need for a tour director, (2) there would be no need for name tags and other customized materials, (3) there would be no need for food and beverages that are provided to a group, and (4) there would be no administrative charges for special services.
Brightspot believes a 30% discount for group incentive travel is reasonable and justifiable to remove additional costs that a leisure vacation would exclude, such as group function costs (for audiovisual, lighting, entertainment, and setup charges), the extra premium for catered event food over restaurant costs, private group excursions and activities, event website, site inspection visits, and the incentive travel company management fee.
Even if the employee portion of the incentive trip is deemed a business meeting and not taxable to the attendee (notice we did not say “winner”), the value of the trip attributable to a spouse or guest is always taxable because their presence is unnecessary for a business meeting.
If the recipient of a prize or award is an employee, the fair market value of the prize or award is deemed to be wages earned that are reported on their Form W-2 and are subject to federal and state payroll tax withholding. Technically, this imputed income should be reported quarterly to include it in a company’s quarterly payroll tax returns.
If the recipient of the award is an independent contractor (a dealer, distributor, independent sales agent, channel partner sales representative, and so forth), the FMV of the award is reported on Form 1099-NEC if the aggregate value of all compensation to the individual is $600 or more in the calendar year. The IRS considers this “nonemployee compensation” defined as fees, commissions, prizes, and awards for services performed as a nonemployee. The payer is not required to issue Form 1099 to a corporation. The IRS does not require withholding of payroll taxes for independent contractors.
TIP #1 – Simplify Tax Reporting – Brightspot recommends using an incentive software platform, such as Ignite, to capture an independent contractor’s social security number (SSN) via a secure online form and then store the SSN in an encrypted database.
TIP #2 – Lower Reported Values to Save Taxes – Smart incentive companies offer the professional expertise to calculate the lowest FMV, which saves the company and participant on taxes. Further, they can assist with filing the Form 1099s.
As a general rule, the recipient of an award is deemed to have received it for income tax purposes when it is credited to their account, set apart for them, or made unconditionally available to them. Treas. Reg. § 1.451-2. Therefore, as a practical matter, the prize or award could be deemed taxable to the employee or independent contractor as soon as they can use it without substantial restrictions or limitations.
Point programs are tricky. Are points taxable when credited to the participant account or actually redeemed? Common sense is when something is actually received, whether it’s travel, merchandise, or a gift card, and most recipients expect they will be taxed when they redeem. The IRS says income is “constructively received” and taxable if it is credited to a taxpayer’s account, set apart for them, and available to draw upon. However, it is not constructively received if it is subject to substantial limitations, restrictions, or risk of forfeiture.
Most companies will report the points as taxable income upon redemption rather than upon crediting points. Most incentive programs require certain thresholds must be achieved for redemption and require that the participant (and possibly their company) must continue to qualify for the program. The requirement to continuously qualify for eligibility creates a risk of forfeiture. The potential forfeiture of points upon the termination of employment is another common risk of forfeiture. Even a participant possibly forgetting about their points (or, in IRS legal language, declining to accept their award) is another valid reason to tax points only when redeemed.
As a general rule, the recipient of an award is deemed to have received it for income tax purposes when it is credited to their account, set apart for them, or made unconditionally available to them. Treas. Reg. § 1.451-2. Therefore, as a practical matter, the prize or award could be deemed taxable to the employee or independent contractor as soon as they can use it without substantial restrictions or limitations.
Point programs are tricky. Are points taxable when credited to the participant account or actually redeemed? Common sense is when something is actually received, whether it’s travel, merchandise, or a gift card, and most recipients expect they will be taxed when they redeem. The IRS says income is “constructively received” and taxable if it is credited to a taxpayer’s account, set apart for them, and available to draw upon. However, it is not constructively received if it is subject to substantial limitations, restrictions, or risk of forfeiture.
Most companies will report the points as taxable income upon redemption rather than upon crediting points. Most incentive programs require certain thresholds must be achieved for redemption and require that the participant (and possibly their company) must continue to qualify for the program. The requirement to continuously qualify for eligibility creates a risk of forfeiture. The potential forfeiture of points upon the termination of employment is another common risk of forfeiture. Even a participant possibly forgetting about their points (or, in IRS legal language, declining to accept their award) is another valid reason to tax points only when redeemed.
The valuation percentages set forth above are only guidelines that an employer or any other person giving prizes or awards may use in determining the fair market value of merchandise and travel awards. The studies by Carlson are an attempt to interpret technical IRS regulations regarding valuation. Each employer or other taxpayer is entitled to determine the FMV of prizes or awards, as long as its methodology is defensible.
Nonetheless, awards given in the form of travel or merchandise instead of cash or cash equivalents may be preferable for tax and business reasons. One tax advantage of merchandise or travel is that its fair market value for reporting on Form W-2 or 1099-MISC may be lower than its cost to the employer. Thus, the amount of tax payable by the recipient would be lower than if cash were used. Cash awards cannot provide any such tax savings to the recipient. In addition, merchandise has the added non-tax benefits of providing continued motivation and encouraging saving for a reward (the recipient can earn points for a more valuable prize and then can use that prize, whether it be electronic, housewares, or golf clubs, for years), creating an emotional attachment for the recipient or having “trophy” value (the recipient can point to having earned something tangible), and requiring the recipient to visualize a prize and work toward receiving it. On the other hand, an employee or independent contractor may view cash simply as additional pay that can be relatively insignificant. Moreover, an employee or independent contractor may also see a cash award as part of their compensation, which may create a disincentive if it is not received in later years as well.
Acknowledgment – Certain portions of these guidelines were originally written by George B. Delta, Esq. and published by an industry trade group named the Incentive Performance Center. The IPC ceased and the website has been removed, but Brightspot believed this incentive industry resource was extremely valuable and that it should be archived here. We give credit and appreciation to both Mr. Delta and IPC. Through the years, Brightspot has expanded the original content with additional tax information.
