Providing Employees with a Nontaxable Discount on Goods

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from PPC Tax Planning Guide—Closely Held Corporations, 14th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown and Kim L. Saunders, published by Practitioners Publishing Company, Fort Worth, Tex. ((800) 323-8724; www.ppcnet.com).

Facts: Pat Lyons owns 100% of the stock of Notes, Inc. (Notes), a store that sells only sheet music. The store is in its second year of operations. All music costs Notes $2 per sheet and is sold for $4 to the general public. However, it is sold for $3 to members of the Piano Teachers Guild. Sales to guild members comprised 40% of Notes’ sales in its first year of existence. In that year, sales totaled $180,000, and cost of sales was $100,000. • All of Notes’ employees are students in the music school of the local university. Pat would like to provide some type of nontaxable fringe benefit to these employees. However, after talking to her insurance agent, she has determined that the more common types of fringe benefits (life and health insurance) would be prohibitively expensive for her relatively new business. She has consulted her tax adviser for guidance about other available benefits. Issue:What type of benefit can Pat provide that does not result in taxable income to her employees and not deplete the new business’s limited resources?

Analysis

Because all Notes employees are music students who supposedly are interested in purchasing Notes’ sheet music, the tax adviser might recommend an employee discount. An employee discount is the excess of the price at which a property is offered for sale to nonemployee customers over the price at which it is provided by the employer for the employee’s use.

An employee can exclude from income qualified employee discounts (i.e., a discount not in excess of the gross profit percentage (GPP) at which property is offered for sale to customers). Thus, if a corporation sells books at a 40% gross profit, but allows employees to purchase books at a 50% discount off the retail price, the employees must generally include the 10% difference in income.

The GPP is based on the aggregate sales price and cost of property sold during a representative period (generally, the tax year preceding the year in which an employer makes the discount available), using the following formula:

In this case, the GPP based on the representative period (the initial year of the corporation’s existence) would be 44% (($180,000 – $100,000)/$180,000). In the current year, the employees can receive tax free a discount equal to that amount on any goods they purchase; any discount in excess of that will result in taxable income to them.

If substantial changes in the business at any time indicate that it is inappropriate to use the prior-year’s GPP for the current year, the employer has to redetermine that percentage.

Special rules would apply if the employer offers property at one or more discounted prices to discrete customer groups. Regs. Sec. 1.132-3(b)(2)(iv) provides that if sales at discounted prices make up at least 35% of the employer’s gross sales for the representative period, the employer uses the discounted price in determining the employees’ discount. (Again, the representative period is the employer’s tax year immediately preceding the tax year in which the employer provides the property to employees at a discount.)

If the employer provides several levels of discounts, it reduces the current undiscounted price by the percentage discount at which it makes the greatest percentage of the discounted gross sales for the representative period, to arrive at the applicable discounted price.

Notes meets the requirements under Regs. Sec. 1.132-3(b)(2)(iv) because sales at a discounted price total at least 35% of its gross sales for the prior tax year. Thus, if Notes offers to sell sheet music to its employees in the current year for $2.50, the discount would be only 50 cents ($3 for music sold to guild members, less $2.50 for music available to employees). Because this discount does not exceed the 44% GPP, the employees would not have to report any taxable income on the fringe benefit.

Conclusion

The tax adviser can recommend that Pat allow her employees to purchase sheet music at a discount. As long as the employees do not receive a discount in excess of the 44% GPP, the benefit will be tax free.