Employment income: wages and fringe benefits

For most Americans, wages are the largest source of income. Section 61(a)(1) includes "compensation for services, including fees, commissions, fringe benefits, and similar items" in gross income, and the regulations say that compensation paid in any form other than cash is income at its fair market value. Fringe benefits are therefore taxable unless a specific provision excludes them, and the Code contains many such exclusions. This lesson starts with the question that decides which rules apply, whether a worker is an employee or an independent contractor, then covers wages and their timing, the major statutory exclusions, the valuation of taxable fringe benefits, reimbursements, and how all of it appears on Form W-2. Lesson 5 continues with equity compensation, payroll taxes and the very limited deductions an employee can claim.

Employee or independent contractor?

The distinction between an employee and an independent contractor matters enormously. An employee receives a Form W-2, has income tax and FICA withheld, and since 2018 can deduct almost no unreimbursed job expenses. An independent contractor receives a Form 1099-NEC if paid $600 or more (rising to $2,000 for payments made after 2025 under the 2025 act, indexed later), reports income and expenses on Schedule C, pays self-employment tax of 15.3 percent on net earnings, and may claim the qualified business income deduction. Employers who misclassify workers face back payroll taxes, interest and penalties, and may also face claims under labor laws, which use their own tests.

The IRS and the courts apply a common-law test that asks whether the business has the right to direct and control how the work is done, not merely the result. The IRS groups the evidence into three categories: behavioral control (instructions, training, evaluation of how the work is done), financial control (significant investment, unreimbursed expenses, opportunity for profit or loss, offering services to the market, method of payment) and the relationship of the parties (written contracts, benefits, permanency, whether the services are a key activity of the business). Either party can ask the IRS for a determination on Form SS-8, and section 530 of the Revenue Act of 1978 gives employers relief from federal employment taxes if they had a reasonable basis for treating workers as contractors and treated them consistently. Labels in a contract do not decide the question; the facts do.

Leah's two activities show the distinction. At Red River she works the hours her manager sets, uses the company's equipment and procedures, is paid a salary with benefits and does work that is a key part of the company's business: she is an employee. Brandt Aerial is her own business: she owns the drones, chooses her clients, sets her prices, advertises and bears the risk of loss if a client does not pay or a drone crashes. The same person can have both kinds of income in the same year, and the Brandts' return will include both a W-2 and a Schedule C.

Wages and their timing

Wages include salaries, bonuses, commissions, vacation pay, severance and tips. Employees are taxed on wages when actually or constructively received. Nonqualified deferred compensation plans let executives postpone receiving salary or bonuses to a later year, but section 409A imposes strict rules on the timing of deferral elections and distributions; a plan that fails them causes all deferred amounts to be taxed immediately, with a 20 percent additional tax and interest. Severance pay and back-pay awards are wages, and settlements of employment disputes are wages to the extent they replace lost pay. Tips are taxable and must be reported to the employer; for 2025 through 2028 the 2025 act allows a deduction of up to $25,000 for qualified tips in occupations that customarily receive them, phased out above $150,000 of modified AGI ($300,000 joint), but the tips remain wages for payroll tax purposes.

The employer reports wages on Form W-2, which shows taxable wages in box 1, Social Security wages in box 3, Medicare wages in box 5, federal income tax withheld in box 2, and many coded amounts in box 12, such as elective deferrals to a 401(k) (code D), employer health coverage cost (code DD, reported but not taxed) and the taxable cost of group-term life insurance over $50,000 (code C). Because 401(k) deferrals are excluded from income tax but not from payroll taxes, box 1 is usually lower than boxes 3 and 5.

Fringe benefits: the exclusions

Because section 61 includes all compensation, the question for any fringe benefit is whether an exclusion applies. Section 132 provides several of the most common ones, many subject to nondiscrimination rules that deny the exclusion to highly compensated employees if the benefit is not offered broadly. Other sections exclude employer-provided health and accident coverage (section 106) and benefits paid under it (section 105), group-term life insurance up to $50,000 of coverage (section 79), meals and lodging furnished on the business premises for the employer's convenience (section 119), up to $5,250 of educational assistance, including payments on the employee's student loans (section 127), and dependent care assistance of up to $7,500 a year starting in 2026 (section 129, as amended in 2025). Benefits that are not excluded are valued under the regulations, generally at fair market value.

Taxable fringe benefits that do not qualify for an exclusion are valued under Treasury Regulation 1.61-21. For an employer-provided car, the regulations offer the general valuation rule (fair market value of the personal use), the annual lease value rule, the cents-per-mile rule for lower-value cars, and the commuting rule, which values commuting-only use at $1.50 each way. Below-market loans to employees create imputed interest income under section 7872, measured at the applicable federal rate. Employer-paid personal expenses, such as a gym membership off the premises, are wages at their full cost.

Reimbursements: accountable and nonaccountable plans

Amounts paid to an employee for business expenses are excluded from wages only if paid under an accountable plan, which requires a business connection, substantiation of the expenses within a reasonable period, and the return of any excess. Reimbursements and allowances under a plan that fails these rules are nonaccountable and taxable as wages, subject to withholding. Mileage allowances at or below the IRS standard mileage rate, and per diem allowances at or below federal rates, are treated as substantiated if the employee documents the time, place and business purpose. Because employees can no longer deduct unreimbursed business expenses, having the employer reimburse under an accountable plan is much more valuable than a salary increase of the same amount.

Valuing a company car

When an employer provides a car, business use is excluded as a working condition fringe, and personal use, including commuting, is a taxable fringe. Under the annual lease value rule, the employer finds the car's fair market value when first provided, looks up its annual lease value in the IRS table and multiplies by the personal-use percentage; fuel provided is added at fair market value or a cents-per-mile amount. The cents-per-mile rule, available for cars below an indexed value that are used regularly in business or driven a minimum distance, multiplies personal miles by the standard mileage rate. The commuting rule, available when the employer requires the employee to commute in the car for business reasons and prohibits other personal use, values each one-way commute at $1.50. Employers must keep records of business and personal miles to support whichever method they use.

The program below computes the wage amounts on Leah's 2026 Form W-2 and lists the benefits she receives tax-free.

# Wages and fringe benefits on Leah's Form W-2, 2026 (illustrative)
age, coverage, salary = 41, 400_000, 96_000
table_i = {(40, 44): 0.10, (45, 49): 0.15}       # IRS Table I, $ per $1,000 per month
rate = next(r for (lo, hi), r in table_i.items() if lo <= age <= hi)
gtl = (coverage - 50_000) / 1_000 * rate * 12    # coverage above $50,000 is taxable

pay = {"Salary": salary, "Bonus": 6_000, "Group-term life over $50,000 (Table I)": gtl,
       "Fitness club membership (taxable fringe)": 900}
deferral_401k = 9_000
box1 = sum(pay.values()) - deferral_401k
box3 = min(sum(pay.values()), 184_500)           # Social Security wages
box5 = sum(pay.values())                         # Medicare wages
for k, v in pay.items():
    print(f"{k:<44}{v:>10,.2f}")
print(f"{'Less 401(k) elective deferral':<44}{-deferral_401k:>10,.2f}")
print(f"{'Box 1  wages, tips, other compensation':<44}{box1:>10,.2f}")
print(f"{'Box 3  Social Security wages':<44}{box3:>10,.2f}")
print(f"{'Box 5  Medicare wages':<44}{box5:>10,.2f}")
excluded = {"Employer health premiums (sec. 106)": 14_800,
            "Transit pass, 12 x $300 (sec. 132(f))": 3_600,
            "Accountable-plan mileage refund": 1_680}
for k, v in excluded.items():
    print(f"  excluded: {k:<38}{v:>10,.2f}")

Salary                                       96,000.00
Bonus                                         6,000.00
Group-term life over $50,000 (Table I)          420.00
Fitness club membership (taxable fringe)        900.00
Less 401(k) elective deferral                -9,000.00
Box 1  wages, tips, other compensation       94,320.00
Box 3  Social Security wages                103,320.00
Box 5  Medicare wages                       103,320.00
  excluded: Employer health premiums (sec. 106)    14,800.00
  excluded: Transit pass, 12 x $300 (sec. 132(f))   3,600.00
  excluded: Accountable-plan mileage refund         1,680.00

Leah's box 1 wages are $94,320: salary and bonus, plus two taxable fringe benefits, minus her $9,000 elective deferral to the 401(k). The group-term life insurance cost is taxable only for coverage above $50,000, and it is computed from the IRS Table I rate, not the employer's actual premium: $350,000 of excess coverage at 10 cents per $1,000 per month for her age group gives $420. The fitness club is off the premises, so no exclusion applies. Boxes 3 and 5 are $103,320, because 401(k) deferrals are subject to payroll taxes. Her employer-paid health coverage, her transit pass (within the $340 monthly limit) and mileage reimbursed under an accountable plan are all excluded.