Adoption Assistance

You can exclude payments or reimbursements you make under an adoption assistance program for an employee's qualified adoption expenses of up to $10,000 per qualifying child from the employee's wages subject to federal income tax withholding. However, you cannot exclude these payments from wages subject to social security, Medicare, and federal unemployment taxes. For more information, see Publication 968, Tax Benefits for Adoption.

Beginning in 2003, you may exclude $10,000 from an employee's wages for the adoption of a child with special needs regardless of whether the employee has qualified adoption expenses. The determination that an adopted child is qualified as a child with special needs must be made by the employee's state.

Employee.   For this exclusion, do not treat a 2% shareholder of an S corporation as an employee of the corporation. A 2% shareholder is someone who directly or indirectly owns (at any time during the year) more than 2% of the corporation's stock or stock with more than 2% of the voting power.

Athletic Facilities

You can exclude the value of an employee's use of an on-premises gym or other athletic facility you operate from the employee's wages if substantially all use of the facility during the calendar year is by your employees, their spouses, and their dependent children. For this purpose, an employee's dependent child is a child or stepchild who is the employee's dependent or who, if both parents are deceased, is age 24 or younger.

On-premises facility.   The athletic facility must be located on premises you own or lease. It does not have to be located on your business premises. However, the exclusion does not apply to an athletic facility for residential use, such as athletic facilities that are part of a resort.

Employee.   For this exclusion, treat the following individuals as employees.

1. A current employee.
2. A former employee who retired or left on disability.
3. A widow or widower of an individual who died while an employee.
4. A widow or widower of a former employee who retired or left on disability.
5. A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction or control.
6. A partner who performs services for a partnership.

De Minimis (Minimal) Benefits

You can exclude the value of a de minimis benefit you provide to an employee from the employee's wages. A de minimis benefit is any property or service you provide to an employee that has so little value (taking into account how frequently you provide similar benefits to your employees) that accounting for it would be unreasonable or administratively impracticable. Cash, no matter how little, is never excludable as a de minimis benefit, except for occasional meal money or transportation fare.

Examples of de minimis benefits include the following:

• Copying machine use. Occasional personal use of a company copying machine, if you sufficiently control its use so that at least 85% of its use is for business purposes, is a de minimis benefit.
• Holiday gifts. Holiday gifts, other than cash, with a low fair market value are de minimis benefits.
• Life insurance on spouse or dependent. Group-term life insurance payable on the death of an employee's spouse or dependent is a de minimis benefit if the face amount is not more than $2,000.
• Meals. De minimis meals are discussed under Meals, later.
• Parties and picnics. Occasional parties or picnics for employees and their guests are de minimis benefits.
• Tickets for entertainment or sporting events. Occasional tickets for entertainment or sporting events are de minimis benefits.
• Transportation fare. De minimis transportation fare is discussed under Transportation (Commuting) Benefits, later.
• Typing. Occasional typing of personal letters by a company secretary is a de minimis benefit.

Employee.   For this exclusion, treat any recipient of a de minimis benefit as an employee.

Dependent Care Assistance

This exclusion applies to household and dependent care services you pay for (directly or indirectly) or provide to an employee under a dependent care assistance program that covers only your employees. The services must be for a qualifying person's care and must allow the employee to work. These requirements are basically the same as the tests the employee would have to meet to claim the dependent care credit if the employee paid for the services. For more information, see Qualifying Person Test and Work-Related Expense Test in Publication 503, Child and Dependent Care Expenses.

Employee.   For this exclusion, treat the following individuals as employees.

1. A current employee.
2. A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction or control.
3. Yourself (if you are a sole proprietor).
4. A partner who performs services for a partnership.

Exclusion from wages.   You can exclude the value of benefits you provide to an employee under a dependent care assistance program from the employee's wages if you reasonably believe that the employee can exclude the benefits from gross income.

An employee can generally exclude from gross income up to $5,000 of benefits received under a dependent care assistance program each year. This limit is reduced to $2,500 for married employees filing separate returns.

However, the exclusion cannot be more than the earned income of either:

1. The employee, or
2. The employee's spouse.

Special rules apply to determine the earned income of a spouse who is either a student or not able to care for himself or herself. For more information on the earned income limit, see Publication 503.

Exception for highly compensated employees.   You cannot exclude dependent care assistance from the wages of a highly compensated employee unless the benefits provided under the program do not favor highly compensated employees and the program meets the requirements described in section 129(d) of the Internal Revenue Code.

For this exclusion, a highly compensated employee for 2002 is an employee who meets either of the following tests.

1. The employee was a 5% owner at any time during the year or the preceding year.
2. The employee received more than $90,000 in pay for the preceding year.

You can choose to ignore test (2) if the employee was not also in the top 20% of employees when ranked by pay for the preceding year.

Form W-2.   Report the value of all dependent care assistance you provide to an employee under a dependent care assistance program in box 10 of the employee's Form W-2. Include any amounts you cannot exclude from the employee's wages in boxes 1, 3, and 5.

Educational Assistance

This exclusion applies to educational assistance you provide to employees under an educational assistance program. For expenses relating to courses beginning in 2002, the exclusion also applies to graduate level courses.

Educational assistance means amounts you pay or incur for your employees' education expenses. These expenses generally include the cost of books, equipment, fees, supplies, and tuition. Also, these expenses do not include the cost of a course or other education involving sports, games, or hobbies, unless the education:

1. Has a reasonable relationship to your business, or
2. Is required as part of a degree program.

Education expenses do not include the cost of tools or supplies (other than textbooks) that your employee is allowed to keep at the end of the course. Nor do they include the cost of lodging, meals, or transportation.

Educational assistance program.   An educational assistance program is a separate written plan that provides educational assistance only to your employees. The program qualifies only if all of the following tests are met.

1. The program benefits employees who qualify under rules set up by you that do not favor highly compensated employees. To determine whether your program meets this test, do not consider employees excluded from your program who are covered by a collective bargaining agreement if there is evidence that educational assistance was a subject of good-faith bargaining.
2. The program does not provide more than 5% of its benefits during the year for shareholders or owners. A shareholder or owner is someone who owns (on any day of the year) more than 5% of the stock or of the capital or profits interest of your business.
3. The program does not allow employees to choose to receive cash or other benefits that must be included in gross income instead of educational assistance.
4. You give reasonable notice of the program to eligible employees.

Your program can cover former employees if their employment is the reason for the coverage.

For this exclusion, a highly compensated employee for 2002 is an employee who meets either of the following tests.

1. The employee was a 5% owner at any time during the year or the preceding year.
2. The employee received more than $90,000 in pay for the preceding year.

You can choose to ignore test (2) if the employee was not also in the top 20% of employees when ranked by pay for the preceding year.

Employee.   For this exclusion, treat the following individuals as employees.

1. A current employee.
2. A former employee who retired, left on disability, or was laid off.
3. A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction or control.
4. Yourself (if you are a sole proprietor).
5. A partner who performs services for a partnership.

Exclusion from wages.   You can exclude up to $5,250 of educational assistance you provide to an employee under an educational assistance program from the employee's wages each year.

Assistance over $5,250.   If you do not have an educational assistance plan, or you provide an employee with assistance exceeding $5,250, you can exclude the value of these benefits from wages if they are working condition benefits. Property or a service provided is a working condition benefit to the extent that if the employee paid for it, the amount paid would have been deductible as a business or depreciation expense. See Working Condition Benefits, later.

Form 5500.   Generally, if you maintain an educational assistance program, you must report information about the program each year by the last day of the 7th month after the program year ends. Use Form 5500 and Schedule F (Form 5500). However, if the education assistance program provides only job-related training that is deductible by the employee as an ordinary and necessary business expense, you are not required to file Form 5500. See the form instructions for information on extensions of time to file.

Employee Discounts

This exclusion applies to a price reduction you give an employee on property or services you offer to customers in the ordinary course of the line of business in which the employee performs substantial services. However, it does not apply to discounts on real property or discounts on personal property of a kind commonly held for investment (such as stocks or bonds).

Employee.   For this exclusion, treat the following individuals as employees.

1. A current employee.
2. A former employee who retired or left on disability.
3. A widow or widower of an individual who died while an employee.
4. A widow or widower of an employee who retired or left on disability.
5. A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction or control.
6. A partner who performs services for a partnership.

Exclusion from wages.   You can generally exclude the value of an employee discount you provide to an employee from the employee's wages, up to the following limits.

1. For a discount on services, 20% of the price you charge nonemployee customers for the service.
2. For a discount on merchandise or other property, your gross profit percentage times the price you charge nonemployee customers for the property.

Determine your gross profit percentage based on all property you offer to customers (including employee customers) and your experience during the tax year immediately before the tax year in which the discount is available. To figure your gross profit percentage, subtract the total cost of the property from the total sales price of the property and divide the result by the total sales price of the property.

Exception for highly compensated employees.   You cannot exclude from the wages of a highly compensated employee any part of the value of a discount that is not available on the same terms to one of the following groups.

1. All your employees, or
2. A group of employees defined under a reasonable classification you set up that does not favor highly compensated employees.

For this exclusion, a highly compensated employee for 2002 is an employee who meets either of the following tests.

1. The employee was a 5% owner at any time during the year or the preceding year.
2. The employee received more than $90,000 in pay for the preceding year.

You can choose to ignore test (2) if the employee was not also in the top 20% of employees when ranked by pay for the preceding year.

Employee Stock Options

There are three classes of stock options - incentive stock options, employee stock purchase plan options, and nonqualified (nonstatutory) stock options.

Generally, for income tax purposes, incentive stock options and employee stock purchase plan options are excluded from wages both when the options are granted and when they are exercised (unless the stock is disposed of in a disqualifying disposition). However, the spread (between the exercise price and fair market value of the stock at the time of exercise) is included in wages subject to social security, Medicare, and federal unemployment taxes when the options are exercised. Income tax withholding is not required at the time of exercise.

The spread on nonqualified options normally is included in wages for income tax purposes when the options are exercised. (See section 1.83-7 of the regulations.) The spread on nonstatutory options is also subject to social security, Medicare, and FUTA taxes, and income tax withholding at the time of exercise.

The IRS will not enforce the application of social security, Medicare, and FUTA taxes at the time of exercise on the spread on incentive stock options and employee stock purchase plan options, for exercises that occur before January 1, 2003. In addition, if stock acquired pursuant to the exercise of an incentive stock option or employee stock purchase plan option that occurred before January 1, 2003, is subsequently sold in a disqualifying disposition, the income is not subject to income tax withholding. However, the income should be reported to the employee or former employee, generally in box 1 of Form W-2. See Notice 2001-14 (2001-16 I.R.B. 516) for more information.

For more information about employee stock options, see sections 421, 422, and 423 of the Internal Revenue Code and the related regulations.

Group-Term Life Insurance Coverage

This exclusion applies to life insurance coverage that meets all the following conditions.

1. It provides a general death benefit that is not included in income.
2. You provide it to a group of employees. See The 10-employee rule, below.
3. It provides an amount of insurance to each employee based on a formula that prevents individual selection. This formula must use factors such as the employee's age, years of service, pay, or position.
4. You provide it under a policy you carry directly or indirectly. Even if you do not pay any of the policy's cost, you are considered to carry it if you arrange for payment of its cost by your employees and charge at least one employee less than, and at least one other employee more than, the cost of his or her insurance. Determine the cost of the insurance, for this purpose, as explained in the discussion on coverage over the limit under Exclusion from wages, on page 10.

Group-term life insurance does not include the following insurance.

• Insurance that does not provide general death benefits, such as travel insurance or a policy providing only accidental death benefits.
• Life insurance on the life of your employee's spouse or dependent. However, you may be able to exclude the cost of this insurance from the employee's wages as a de minimis benefit. See De Minimis (Minimal) Benefits, earlier.
• Insurance provided under a policy that provides a permanent benefit (an economic value that extends beyond 1 policy year, such as paid-up or cash surrender value), unless certain requirements are met. See section 1.79-1(b) of the regulations for details.

Employee.   For this exclusion, treat the following individuals as employees.

1. A current common-law employee.
2. A full-time life insurance agent who is a current statutory employee.
3. An individual who was formerly your employee under (1) or (2), above.
4. A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction and control.

Exception for S corporation shareholders.   Do not treat a 2% shareholder of an S corporation as an employee of the corporation. A 2% shareholder is someone who directly or indirectly owns (at any time during the year) more than 2% of the corporation's stock or stock with more than 2% of the voting power.

The 10-employee rule.   Generally, life insurance is not group-term life insurance unless you provide it to at least 10 full-time employees at some time during the year.

For this rule, count employees who choose not to receive the insurance unless, to receive it, they must contribute to the cost of benefits other than the group-term life insurance. For example, count an employee who could receive insurance by paying part of the cost, even if that employee chooses not to receive it. However, do not count an employee who must pay part or all of the cost of permanent benefits to get insurance, unless that employee chooses to receive it.

Exceptions.   Even if you do not meet the 10-employee rule, two exceptions allow you to treat insurance as group-term life insurance.

Under the first exception, you do not have to meet the 10-employee rule if all the following conditions are met.

1. If evidence that the employee is insurable is required, it is limited to a medical questionnaire (completed by the employee) that does not require a physical.
2. You provide the insurance to all your full-time employees or, if the insurer requires the evidence mentioned in (1), to all full-time employees who provide evidence the insurer accepts.
3. You figure the coverage based on either a uniform percentage of pay or the insurer's coverage brackets.

Under the second exception, you do not have to meet the 10-employee rule if all the following conditions are met.

1. You provide the insurance under a common plan covering your employees and the employees of at least one other employer who is not related to you.
2. The insurance is restricted to, but mandatory for, all your employees who belong to or are represented by an organization (such as a union) that carries on substantial activities besides obtaining insurance.
3. Evidence of whether an employee is insurable does not affect an employee's eligibility for insurance or the amount of insurance that employee gets.

To apply either exception, do not consider employees who were denied insurance for any of the following reasons.

1. They were 65 or older.
2. They customarily work 20 hours or less a week or 5 months or less in a calendar year.
3. They have not been employed for the waiting period given in the policy. This waiting period cannot be more than 6 months.

Exclusion from wages.   You can generally exclude all group-term life insurance coverage you provide to an employee from the employee's wages subject to federal income tax withholding and federal unemployment tax. In addition, you can exclude the cost of up to $50,000 of coverage from wages subject to social security and Medicare taxes.

Exception for key employees.   Generally, if your group-term life insurance plan favors key employees as to participation or benefits, you must include the entire cost of the insurance in your key employees' wages subject to social security and Medicare taxes. You must also include the entire cost of the insurance in the employees' wages shown in boxes 1, 3, and 5 of Form W-2. However, you can exclude the cost of this insurance from the employees' wages subject to federal income tax withholding and federal unemployment tax.

This exception generally does not apply to church plans.

For this purpose, the cost of the insurance is the greater of the following amounts.

1. The premiums you pay for the employee's insurance.
2. The cost you figure using the table shown later under Coverage over the limit.

For this exclusion, a key employee during 2002 is an employee or former employee who is one of the following individuals. See section 416(i) for more information.

1. An officer having annual pay of more than $130,000.
2. An individual who for 2002 was either of the following:
   1. A 5% owner of your business.
   2. A 1% owner of your business whose annual pay was more than $150,000.

A former employee who was a key employee upon retirement or separation from service is also a key employee.

Your plan does not favor key employees as to participation if at least one of the following is true.

1. It benefits at least 70% of your employees.
2. At least 85% of the participating employees are not key employees.
3. It benefits employees who qualify under a set of rules you set up that do not favor key employees.

Your plan meets this participation test if it is part of a cafeteria plan (discussed in section 1) and it meets the participation test for those plans.

When applying this test do not consider employees who:

1. Have not completed 3 years of service.
2. Are part time or seasonal.
3. Are nonresident aliens who receive no U.S. source earned income from you.
4. Are not included in the plan but are in a unit of employees covered by a collective bargaining agreement, if the benefits provided under the plan were the subject of good-faith bargaining between you and employee representatives.

Your plan does not favor key employees as to benefits if all benefits available to participating key employees are also available to all other participating employees. Your plan does not favor key employees just because the amount of insurance you provide to your employees is uniformly related to their pay.

S corporation shareholders.   Because you cannot treat a 2% shareholder of an S corporation as an employee for this exclusion, you must include the value of all group-term life insurance coverage you provide the employee in the employee's wages subject to social security and Medicare taxes. You must also include the value of this coverage in the employee's wages shown in boxes 1, 3, and 5 of Form W-2. However, you can exclude the value of this coverage from the employee's wages subject to federal income tax withholding and federal unemployment tax.

Coverage over the limit.   You must include in your employee's wages subject to social security and Medicare taxes the cost of group-term life insurance that is more than the cost of $50,000 of coverage, reduced by the amount the employee paid toward the insurance. Report it as wages in boxes 1, 3, and 5 of the employee's Form W-2. Also, show it in box 12 with code C.

Former employees must pay the employee's part of social security and Medicare taxes on the cost of the excess coverage with their Form 1040. You are not required to collect these taxes. Report the uncollected social security tax with code M and the uncollected Medicare tax with code N in box 12 of Form W-2.

Figure the monthly cost of the insurance to include in the employee's wages by multiplying the number of thousands of dollars of insurance coverage over $50,000 (figured to the nearest $100) by the cost shown in the following table. Use the employee's age on the last day of the tax year. You must prorate the cost from the table if less than a full month of coverage is involved.

COST PER $1,000 OF PROTECTION FOR ONE MONTH

Age	Cost
Under 25	$ .05
25 through 29	.06
30 through 34	.08
35 through 39	.09
40 through 44	.10
45 through 49	.15
50 through 54	.23
55 through 59	.43
60 through 64	.66
65 through 69	1.27
70 and older	2.06

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