Tax Tips for Incentive Programs

Federal income tax considerations for incentive programs often are overlooked. While it is challenging to give technical tax advice that would apply equally to all incentive programs, the following guidelines can help make a program more successful — and avoid unpleasant surprises for award recipients. 

As a rule, incentive prizes and awards earned by individuals based on sales goals, performance, learning or other work-related services are taxable as compensation, regardless of the type of award earned, such as cash, merchandise or travel.

According to Treas. Reg. § 1.74-1, taxable compensation includes both cash and noncash rewards because both are deemed “earned for services rendered,” making them subject to income tax and payroll taxes.

Rules for Merchandise Rewards

If the award is merchandise rather than cash, the reward's fair-market value must be included as income. The Internal Revenue Service does not provide specific rules, but states that fair-market value is based on all the facts and circumstances of the prize, as outlined in IRS Publication 525, Taxable and Nontaxable Income. (Note: These guidelines were originally written by George B. Delta, Esq., and industry guidelines have updated and expanded by Brightspot Incentives & Events.)

To calculate the fair-market value of these rewards, most industry professionals recommend the 30 percent rule, based on a formula established by the former Carlson Marketing (now One10). The rule compares the value of merchandise items offered in a points-based awards catalog with the retail costs of those items, then values them at a 30 percent discount.

The calculation takes into account costs for the marketing and fulfillment services that stores do not incur and do not have to pass through to their customers. These costs include: incentive professional services to create the incentive program; ongoing management of the incentive program; tracking and evaluating results for the program; merchandising services; fulfillment services for each order and processing through a distribution center; website and technology software; and shipping, handling, insurance, administration and sales taxes. For example, if the point value of an HDTV award is $1,000, its fair-market value should be approximately $700.

Rules for Travel Programs

Determining the fair-market value of travel is more complex. In an effort to come up with these values, Carlson Marketing studied its incentive travel costs and compared them with those offered by retail travel agencies on selected trips. They analyzed the cost of land travel (excluding airfare) for a single traveler compared with the cost of the same travel for each person who was part of a group, and reviewed group-travel invoices to determine which components of the cost should be included in the computation of fair-market value.

Carlson concluded that the fair-market value for land travel is 73 to 76 percent. Thus, as a general rule, a 25 percent discount is deemed acceptable. The company also concluded that no discount was appropriate for air travel, although, presumably, the fair-market value of air travel could be determined by referencing discount travel fares. If the employer or the incentive company purchases the airfare, then the ticket’s purchase price should also be its fair-market value for tax purposes. 

Brightspot believes that a slightly larger discount — 30 percent — for group incentive travel is reasonable and justifiable to remove additional costs that a leisure vacation would exclude, such as group-function fees (for audiovisual, lighting, entertainment and setup charges), the extra premium for catered events over restaurant costs, private group excursions and activities, the event website, site inspections, and the incentive travel company's management fee.

Travel Reward or Meeting?

A common question for travel rewards is whether the trip can be excluded from a recipient's tax return if a business meeting is held during the program. Unfortunately, the IRS does not provide clear guidelines on this, broadly stating it depends on all the facts and circumstances. Merely holding a one-hour meeting on day two will not make a five-night trip to the Caribbean nontaxable for the winners.

We have seen some companies evaluate the total hours of the itinerary that are spent in business functions (such as a three-hour welcome reception that could be considered a networking event, any structured business meetings, the awards celebration itself, team-building activities, and even mandatory group tours, such as a catamaran sail attended by the entire group) and compare that with the sum of the eight-hour days included in the trip. If the business hours are greater than 50 percent of the total workday hours, some companies determine the trip’s primary purpose is a business meeting and is therefore nontaxable for the attendees. (Contact Brightspot for a copy of this tax agenda.)

Even if the employee portion of the incentive trip is deemed nontaxable for the attendee (notice we did not say “winner” here), the value of the trip for a spouse or guest is always taxable because they are essentially on vacation.

Employee Achievement Awards

The IRS created a special exemption from taxes 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 your length of service or a safety achievement, you might 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 give out the award as part of a meaningful presentation, under conditions and circumstances that don’t create a significant likelihood of it being disguised as 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’re a manager, administrator, clerical employee or other professional employee, or if more than 10 percent of eligible employees previously have received safety-achievement awards during the year.

Income Tax–Reporting Requirements

If the recipient of an award is an employee, the fair-market value of the prize is deemed to be wages earned that are reported on their W-2 form and are subject to federal and state withholding. Technically, this income should be reported quarterly to be included in the company’s quarterly payroll tax returns.

If the recipient of the award is an independent contractor (a dealer, a distributor, an independent sales agent, a channel partner representative and so forth), the fair-market value of the award should be reported on their 1099-MISC form if the aggregate value of all compensation to the individual is $600 or more in the calendar year. The payer is not required to issue a 1099 to a corporation, however, and the IRS does not require withholding of payroll taxes for independent contractors.

We recommend using an incentive software platform to capture an independent contractor’s social security number in a secure online form, to be stored in an encrypted database. Good incentive companies offer the professional expertise to calculate the lowest fair-market value, which saves the company and participant on taxes. Further, they can assist with filing the 1099s.

Timing of Earnings

Generally, 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. Therefore, as a practical matter, the prize could be deemed taxable as soon as it is available.

More tricky are points programs, where winners select their reward based on the totals they accumulate during a program. Are the points taxable when credited to the participant's account or after they are redeemed? 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, the reward is not constructively received if it is subject to substantial limitations, restrictions or risk of forfeiture.

Most companies report the points as taxable income upon redemption rather than when the points are credited to the participant's account. Most incentive programs require certain thresholds to be achieved for redemption, and require that the participant (and possibly their company) continue to qualify for the program. This requirement creates that risk of forfeiture; the termination of employment is another common risk of forfeiture. And if a participant forgets about their points (or, in IRS legal language, declines to accept their award), that's another valid reason to tax points only when redeemed.

Noncash Tax Advantage

The valuation percentages set forth above are only guidelines for organizations that run incentive programs to use for determining the fair-market value of rewards. Each employer or other taxpayer is entitled to determine the fair-market value of the awards, as long as the methodology is defensible.

Nonetheless, taxwise, it might be preferable to give travel or merchandise rewards instead of cash or cash equivalents. One tax advantage of merchandise or travel is that the fair-market value for reporting on W-2 or 1099 forms might be lower than its cost to the employer. Thus, the amount of tax payable by the recipient would be lower than if cash were given. Cash awards cannot provide any such tax savings to the recipient.

In addition, merchandise has the nontax benefit of providing continued motivation and encourages savings for the reward (the recipient can earn points for a more valuable prize, and often can use that prize for years), creating an emotional attachment for the recipient and giving the reward “trophy” value. On the other hand, an employee or independent contractor might view cash simply as additional pay that can be relatively insignificant. An employee or independent contractor might also see a cash award as part of their compensation, which could cause disappointment if it is not received in later years. 

Mike May, CMP, CITP, IP, is president & owner of Brightspot Incentives & Events. Brightspot is multiple winner of Incentive's annual Motivation Masters Awards, which honor the industry's top motivation and incentive programs.