Payroll Brass Tax: Holiday Gifts, Gift Cards, and the Taxable Truth

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Mike Mahoney: Welcome to Payroll Brass Tax, where we demystify payroll, HR, and compliance so you can run your business with confidence. I’m Mike Mahoney, a shareholder in Ogletree’s Morristown, New Jersey and New York City offices, and today’s episode tackles holiday gifts to employees. The bottom line is fairly clear. With narrow exceptions, holiday gifts are taxable wages subject to income tax withholding and employment taxes. Gift cards are almost always taxable. Raffle and door prize winnings are taxable. Vendor provided items handed out by the employer are taxable, and missteps can really snowball on audit. We’re going to unpack what is and is not taxable, how de minimis fringe benefit rules actually work, how to handle raffles, what changes when vendors are involved, and how to avoid audit landmines.
Joining me today is Stephen Kenney, an associate in Ogletree’s Dallas, Texas office.

Stephen Kenney: Well, thanks for having me, Mike. That’s quite a list you’ve got for us to run through. I think the quick takeaway for busy teams is going to be to treat most holiday gifts as wages, unless they are confident that they fit within the de minimis fringe benefit exclusion for small infrequent non-cash items. They should also assume that gift cards are going to be taxable as cash equivalents. Raffle prizes at company events are going to count as compensation to employees. And then payroll and HR team should plan ahead for valuation, timing, and withholding, all while communicating with the impacted employees, so to keep the season cheerful and also compliant.

Mike Mahoney: Well, let’s jump right into it, and let’s start with the basics. Are holiday gifts to employees taxable and what are the payroll tax consequences?

Stephen Kenney: So here, we’ve got the general rule. And the general rule is that anything of value an employer provides to an employee is taxable compensation unless a specific exclusion applies. For payroll, that means you include the fair market value of the gift on the Form W2, and you withhold federal income tax and FICA, and you also must account for federal unemployment tax. Most states follow suit when it comes to income tax and unemployment taxes at the state level. Non-cash gifts are valued at the fair market value when the employee receives them reduced by any amount the employee might have paid to receive that benefit or gift.
So, the holiday party itself is typically excludable as an occasional de minimis social event, but the gifts and prizes handed out at the party are not automatically tax free just because they are part of the festive event.

Mike Mahoney: When the gift is of a non-cash type, how do employers practically handle withholding and the employee share of FICA on that non-cash gift?

Stephen Kenney: Well, since it’s a non-cash gift, there’s no cash in the transaction from which to withhold, so you have to plan to be able to fund withholding. Employers either withhold from the employee’s regular wages, salary or hourly amounts, collect funds directly from the employee or gross up the gift so that the employer covers the taxes. Each choice has communication and cost implications, and you should decide before distribution so that employees are not surprised at the tax consequences. If you treat the item as a supplemental wage, you could use the flat supplemental rate for federal withholding, though FICA is always going to apply. Good coordination between HR and payroll helps ensure the inclusion lands in the right pay period and that tax deposits are timely.

Mike Mahoney: Thanks, Stephen. You mentioned before that basically everything will be considered income unless an exclusion applies. I know in many of the conversations I’m having with clients these days, the de minimis fringe benefit exclusion has been coming up. Can you describe what that is and how it applies or may apply to holiday gifts?

Stephen Kenney: Yeah. So, de minimis fringe benefits are those benefits that are so small in value and provided so infrequently that accounting for them would be unreasonable or administratively impracticable. The exclusion applies only to property or services, not to cash or cash equivalents like gift cards because it’s easy to account for cash, and the frequency matters just as much as the dollar value.
Classic holiday examples that can qualify are a turkey, a ham, or a modest gift basket that’s provided only once a year. Company branded swag of low value, that also can be provided occasionally and considered a de minimis fringe benefit. There is no hard dollar safe harbor, but the IRS has said something valued at $100 can never be de minimis, even if provided only once. Some employers should be conservative and document why an item is small and infrequent enough to be impractical to track.

Mike Mahoney: Just in your experience, where do employers go wrong when relying on the de minimis fringe benefit exclusion?

Stephen Kenney: The most common mistake is stretching the definition of de minimis to cover items that are either too valuable or provided too frequently. Monthly snack boxes, recurring event tickets, electronics, or anything that requires careful tracking generally flunks the impracticability test. Another recurring error is assuming small gift cards qualify, which they do not because they are treated as cash equivalent. If you are building spreadsheets to track recipients and values, that’s a signal that the item is probably not de minimis because you are accounting for it. Consistency across employee groups and years strengthens your position if the IRS were to ask any questions later.

Mike Mahoney: You mentioned gift cards, which are a very common gift given around this time of year because they’re so convenient. Are gift cards ever tax-free?

Stephen Kenney: So, as a general rule, gift cards and most gift certificates are going to be taxable wages when provided because they function as cash equivalents. A $10 coffee card, a $20 retail card, or a general use card are all includable in wages and subject to withholding and FICA, even if given only once a year. There is a narrow nuance where a certificate solely for a specific low value item could be treated like the item itself, but most modern cards carry a dollar value and fail that exception. The safest, most practical policy is to treat all gift cards as taxable and process them through payroll. If you want the gesture to feel tax-free, consider a gross up and communicate that plan in advance.

Mike Mahoney: How should employers time and report gift cards for payroll purposes?

Stephen Kenney: So, employers should include the value in wages in the period the card is given, usually December for holiday gifts. You can generally apply the flat supplemental withholding rate and Social Security and Medicare also still apply. Employers should be sure that their payroll system can capture non-cash taxable fringe benefits on the correct check date and plan deposit timing accordingly. Clear employee communications help avoid confusion about why net pay might be lower in a subsequent paycheck.

Mike Mahoney: I want to pivot a little bit away from gift cards and talk about raffles and party prizes at events. So, what are your thoughts on the taxation of raffle or door prizes at a holiday party? How would those winners be taxed?

Stephen Kenney: So, for employee winners, those raffle and door prizes are taxable compensation, and the fair market value of the prize is subject to income tax withholding and FICA. The setting does not change the result. Prizes are treated as wages when won, even if through a game. Because there is no cash, the employer should either withhold from a near term paycheck or gross up at the time of the award so the employee is not left with a tax bill but no cash to satisfy the tax.
Using the supplemental wage withholding rate can simplify administration. Employers should also be sure to document the fair market value, and that is what a willing buyer would pay to support the payroll entries.

Mike Mahoney: What happens if a non-employee guest wins a prize?

Stephen Kenney: So, if the guest wins, they are not your employee, so it is not going to be wages paid by an employer to an employee, but it is still taxable income to the recipient. If the value meets information reporting thresholds, the organization may need to issue a Form 1099 Miscellaneous, which means collecting a Form W9 from the winner. Many employers avoid that complexity by limiting eligibility to employees or by capping prize values at clearly modest levels. If you do allow guest participation, then you should have a plan for collecting recipient information at the event. Clear rules in the party invitation helps set expectations and ease compliance.

Mike Mahoney: Now, one of the questions I’m frequently asked is, what happens if an employer’s vendor provides them with items for free? Does the source of the prize change the tax treatment? So, let’s just come up with an example. Suppose a vendor provides a television and the employer distributes the television to an employee. Does that affect the employee’s tax outcome?

Stephen Kenney: So, here we have an employer receives items from a vendor and then gives them to employees. Still, those items are fringe benefits because it is the employer giving them to the employees, so that’s going to make them wages unless an exclusion like the de minimis exception applies. The employer is responsible for valuing the item at fair market value and handling any income tax withholding and employment taxes. The fact that the employer did not pay for the item does not change the employee’s tax result because it’s still a prize or gift given pursuant to an employment relationship.

Mike Mahoney: Now, what if the vendor gives something directly to an individual employee?

Stephen Kenney: So, direct to employee vendor gifts are generally taxable to the recipient, but they’re not going to be wages because the employer did not provide them and was not involved in identifying the recipient. In some cases, especially where the item is tied to the employee’s work, those amounts are still compensation for services, and the employer can be implicated if it knows the facts and value of the item. Vendors may have their own reporting obligations when thresholds are met. Employers should adopt a policy requiring disclosure of vendor gifts, and then when feasible, channeling them through the company so the tax treatment is clear. This approach also aligns with ethics and conflicts policies that many employers already maintain.

Mike Mahoney: We’ve been talking about a couple of different scenarios of where gifts may be given and the types of gifts that we may see, but let’s talk about some of the mechanics of the valuation, timing, withholding. How should employers value non-cash gifts and when should they report them for payroll purposes?

Stephen Kenney: So, employers should value non-cash gifts by using the fair market value of the item as of the date that the employee can use the item, which is what a willing buyer would pay a willing seller in an arm’s length transaction. Employer cost is not controlling, so discounts or free items do not reduce the employee’s includable amount. Employers need to treat non-cash benefits as paid when provided and consider special accounting methods that allow for you to treat certain non-cash fringe benefits provided late in the year as paid on a single date in November or December to simplify processing.

Mike Mahoney: One of the items that you mentioned earlier was providing a gross-up. How do you approach gross-ups so that the employee feels that they actually receive the full gift?

Stephen Kenney: So, if we think about a gross-up conceptually, it’s starting with the intended net amount, so the intended amount we want the employee to receive and divide by one, minus the applicable withholding and employee FICA rate to arrive at the gross amount. So, the actual percentage depends on whether you use the supplemental wage rate and whether the employee is over the Social Security wage base. Employers should document the methodology they use so payroll applies the gross-up methodology consistently and also consider state and local tax overlays when appropriate. Employers should also communicate to employees whether gifts will reduce their next net pay or be grossed up to a target net. Clarity avoids confusion and preserves goodwill when issuing a gift.

Mike Mahoney: Let’s talk for a minute about what the risks are of getting this wrong. If the IRS or a state agency were to audit and find unreported holiday gifts, what should employers expect at that point?

Stephen Kenney: Employers should expect that the IRS will typically assess back employment taxes, including both the employer and employee shares of FICA, income tax that should have been withheld based on the gift value, and federal unemployment plus interest. Because the employer failed to withhold the necessary employment taxes, the IRS can collect the employee FICA from the employer, which is an unwelcome surprise. Penalties can include failure to deposit penalties, accuracy related penalties, and information return penalties if forms W2 or 1099 were incorrect or missing, and they can be considered incorrect if they don’t properly account for the holiday gift. Interest is also calculated, and it compounds daily at the applicable quarterly rate from when the taxes should have been deposited to when the assessment is ultimately satisfied.

Mike Mahoney: So that’s a bit of doom and gloom. What if an employer identifies that they failed to report a holiday gift? Is there a way for them to fix the issues before an audit increases the table stakes?

Stephen Kenney: Yes, there is. So being proactive and taking self-correction measures is almost always a better approach than waiting for an audit. Employers can file adjusted employment tax returns to true up FICA and withholding. For quarterly employment taxes, that means using a Form 941-X to initiate the adjustment process. The sooner an employer corrects, the less interest accrues, and they can also improve their position to request penalty relief based on reasonable cause.
It also helps to standardize policies going forward. Avoid gift cards if you do not want wages. Instead, favor low value, tangible items given once per year and centralized vendor gifts. Once again, proactive communication to employees reduces confusion and supports compliance.

Mike Mahoney: Thanks for clearly going through those issues, Stephen. Let’s close with the essentials. What should listeners remember as they finalize their holiday gift giving plans?

Stephen Kenney: Well, we set it up front, and we’ll say it here at the end. Most holiday gifts to employees are going to be considered taxable wages, and that includes gift cards and raffle prizes even when given at a company party. The de minimis fringe benefit exclusion under Section 132 of the Internal Revenue Code can exclude certain items from taxable wages, but that really only applies to small infrequent non-cash items, like a once-a-year turkey or modest gift basket. But there is no dollar safe harbor and cash equivalents such as gift cards do not qualify. If a vendor supplies items and the employer distributes them, those items also need to be treated as wages unless they independently meet an exclusion.
In sum, employers need to nail the mechanics. They need to properly value the gift that’s being given to the employee. They need to make sure that they have the timing down in payroll so that they can account for the taxes and withholding that are necessary in a timely manner, and they can gross up the value of any of these gifts in an effort to limit or eliminate the tax consequences to employees when they’re receiving gifts during the holiday season.
So, doing these things will reduce audit risk and also importantly, keep the holiday goodwill intact as you want to celebrate the season with your employees.

Mike Mahoney: Thanks for that, Stephen. That’s today’s episode of Payroll Brass Tax. Share this episode with your HR, finance, and payroll partners so everyone is aligned before the festivities begin. Enjoy the season, and let’s keep the payroll compliant.

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