Employee discount programs are a popular way to reward and retain talent. In some industries, such as veterinary and medspa, offering a discount program is expected. Whether the business provides services, sells products, or both, offering employees a reduced price can feel mutually beneficial and low risk. From a tax perspective, however, these programs are more technical than many employers realize and have income tax consequences.

The first point is that the discount in order for it not to be treated as wages must be provided as a reduced price at the point of sale and cannot take the form of a reimbursement, stipend, or cash payment.

20 Percent Rule for Services

For discounts on services to qualify as a nontaxable fringe benefit, the reduction cannot exceed 20 percent of the price charged to customers. If the discount exceeds 20 percent, the excess over the statutory limit must be treated as taxable wages and processed through payroll, subject to withholding and employment taxes.

I have seen companies offer a “half off” perk to employees for years, only to discover during a payroll audit that the excess should have been reported as compensation. The issue is rarely intentional and often arises when employers follow a competitor’s program without realizing that the excess is required to be treated as wage income.

A Different Rule for Products

A more complex standard applies to product discounts. The maximum tax-free discount is generally limited to the employer’s gross profit percentage on its products, requiring accurate margin tracking and substantiation. Employers sometimes set a flat discount assuming it is “close enough,” only to learn the numbers do not support that assumption.

The gross profit percentage must be calculated within the relevant line of business in which the employee performs services. Employers may not combine high-margin and low-margin products to justify a larger tax-free discount. For example, at an automotive dealership, margins on new vehicle sales are often significantly lower than margins in the parts or service department. If an employer treats those as separate lines of business with separate employees, the permissible discount depends on the line in which the employee provides services.

Many employers intentionally stay below the theoretical maximum to reduce recalculation and audit risk, and employers should retain documentation supporting their margin calculations.

Who’s In and Who’s Not

Eligibility is another common area of confusion. To preserve favorable tax treatment, discount programs generally must be offered on a nondiscriminatory basis and may include spouses and dependent children. In practice, this means the program should be broadly available on similar terms rather than structured to benefit a select group.

Partners and certain S corporation shareholders do not qualify for tax-free treatment of these employee discount perks.  Partners cannot be an employee of a business structured as a partnership.  S corporations are treated as a partnership for fringe benefit purposes, and 2 percent shareholders are treated as partners.  Independent contractors and consultants are not eligible to participate on a tax-free basis.

Payroll and Administrative Coordination

Even a well-designed program can create issues if payroll systems are not aligned. Any excess discount must be included in wages and is subject to withholding. Coordination between point-of-sale and payroll systems is essential to ensure proper tracking and reporting.

Don’t Forget Use Tax

Employers should also consider state sales and use tax implications, particularly when goods are bundled with services. Treatment varies by state and often depends on how transactions are structured and invoiced.

Providing discounted inventory can create use tax exposure, especially if the business claimed a resale exemption at purchase and the items are not resold in the ordinary course.

Design First, Discount Second

Handled correctly, an employee discount program can be a meaningful benefit. Handled incorrectly, it can create tax exposure that outweighs the intended goodwill.  Common consequences include:

  • Failure to withhold and remit federal and state income taxes
  • Failure to withhold and remit FICA and possibly FUTA
  • Interest on underpayments
  • Accuracy-related penalties for incorrect employment tax returns
  • Penalties for failure to file and furnish correct forms W‑2

Less commonly, corrections may be required for qualified retirement plan calculations (e.g., 401(k) matching contributions). If an excessive discount is treated as taxable wages, it is generally included in state unemployment wages, potentially increasing state unemployment tax liability.

Most compliance issues stem from implementation and documentation gaps rather than aggressive planning.  A carefully drafted written policy, coordination between payroll and point-of-sale systems, and periodic review as margins, product lines, or ownership change can prevent a well-intentioned perk from becoming a payroll problem.

An IRS examination is an administrative process in which the IRS evaluates a tax return for the taxpayer’s reported positions, determines whether the underlying facts support those positions, and decides whether to propose adjustments.  Understanding the IRS examination process from return selection through the stages of an audit provides taxpayers who are considering how to file their returns, and for those who have already filed their return, with insight into risk management and best practices.

Returns Selected for Examination

The IRS uses several processes to determine whether to audit a return.  First, the IRS uses a Discriminant Function System (“DIF”) and AI models to analyze the entire return for various criteria, issues, and comparisons to similar returns (i.e., individuals, S corporations, and partnerships).  The return is “scored” based on the extent of potential adjustments that could be made on audit.  Second, higher-scoring returns are reviewed by experienced personnel, who determine which returns should be examined and identify the initial list of issues to review.

The Commencement of an IRS Examination

The taxpayer will receive an IRS audit notice that identifies the tax year(s) under review and the initial issues being examined.  The notice will also identify whether the audit is a correspondence, office, or field audit.  A correspondence audit is conducted by mail and focuses on specific items.  An office audit is conducted by having the taxpayer bring records to a local office for review by a Revenue Agent.  A field audit is conducted by a Revenue Agent at the taxpayer’s home, business, or representative’s office and is a comprehensive review of a taxpayer’s financial records and operations.  For more complex cases, a field audit may be assigned to an examination team.

The Revenue Agent typically reviews prior and subsequent years for comparison purposes.  As the examination proceeds, the Revenue Agent may identify new issues not identified in the audit commencement notice.  The IRS frequently opens related-party examinations, such as the personal returns of the owners of a flow-through entity, or other entities owned by the same person or group, especially where those entities interact financially with each other.

Factual Development

Information gathering is the core of the examination process.  The primary tool used by the IRS is the Information Document Request, which may contain requests for documents, explanations, or factual and legal support for items reported on the return.

Information Document Requests (“IDRs”) are voluntary and not enforceable.  However, most taxpayers and their representatives do respond in order to provide the basis for the taxpayer’s positions on the return.  Where the taxpayer does not voluntarily respond to IDRs, the IRS may issue summonses to the taxpayer or to third parties, as summonses can be enforced in court.

There is an art to responding to IDRs.  “See attached” document responses with no explanation should be used sparingly, and generally only in response to the initial IDR that requests financial and bank statements.  The manner in which a taxpayer responds, including how factual or legal narratives are presented and even how documents are organized, often influences how the Revenue Agent interprets the transaction or position being examined.  The Revenue Agent’s judgments made early in the examination process, particularly with respect to factual and legal explanations, can have lasting effects.  This is why substantive and persuasive IDR responses are highly recommended.

In some cases, the Revenue Agent may request an interview of the taxpayer or company personnel.  The Revenue Agent is not required to provide questions in advance – and never does.  Whether to consent to an interview should be decided after conducting an exposure analysis of any sensitive issues.

Timing and the Statute of Limitations

The statute of limitations is a recurring issue in IRS examinations.  Generally, the IRS has three years from the filing of a return to assess additional tax, although longer periods apply to substantial omissions of income or certain international or other issues.  Once the statute of limitations expires, the IRS cannot assess additional tax for that tax year.

By the time the return is selected for audit, assigned to an agent, and the audit commences, the limitations period is often close to expiring.  Typically, the IRS requests that the taxpayer agree to extend the statute of limitations on assessment.  Whether the taxpayer should consent requires careful consideration.  Extensions can provide additional time to resolve issues at IRS Exam, but they can also give the Revenue Agent time to uncover additional issues on the return.

Taxpayers Strike Back

Taxpayers sometimes raise new issues during an examination.  For example, a taxpayer may have failed to report some deductions and those additional deductions could offset some or all of the Revenue Agent’s proposed adjustments.  The Revenue Agent typically accommodates new issues unless they will delay the resolution of the examination.  Best practice is to raise new issues as early as possible in the exam.

For Whom the Bell Tolls

When the Revenue Agent will propose adjustments, the agent will issue a Notice of Proposed Adjustment (“NOPA”).  A NOPA is a detailed report that explains the adjustments and the factual and legal basis for the IRS’s position on that issue.  The purpose of the NOPA is to provide the taxpayer with an opportunity to dispute the IRS’s view of the facts or law and to submit any additional documentation.

IRS Appeals will not review new facts or new arguments presented for the first time on appeal, so the taxpayer should provide a full response to the NOPA – even though most taxpayers feel they want to keep their cards close.

How Examinations Are Concluded

An IRS examination typically concludes in one of three ways.  The Revenue Agent can accept the return as filed, propose no adjustments, and issue a “no-change” letter.  In an agreed resolution, the Revenue Agent proposes adjustments, and the taxpayer agrees and consents to assessment.

The IRS Examination Division does not have the authority to settle cases based on litigation risk or “hazards.”  IRS Appeals, which is typically the next phase after an IRS examination, includes in its review an evaluation of the hazards of the IRS’s and the taxpayer’s positions.  There are various programs available to involve IRS Appeals at the exam stage in order to reach a “hazards” settlement.

In an unagreed case, the taxpayer disputes some or all of the proposed adjustments.  The taxpayer may have the opportunity to challenge the adjustments with IRS Appeals by timely filing a protest.  Otherwise, the taxpayer can challenge the adjustments before the Tax Court or in district court.

Behind the 8-Ball

By the time adjustments are proposed, the administrative record is generally fixed, and opportunities to reshape the taxpayer’s narrative are limited. 

In appeals and litigation, the IRS’s proposed adjustments are generally “presumed correct.”  The taxpayer bears the burden of proof to demonstrate its return position, and the applicable standard is by a preponderance of the evidence.  Preponderance means the taxpayer’s position is more likely than not correct or more likely correct than the IRS’s position (i.e., just over 50 percent).   While the standard does not seem like a high bar, in practice, it is.  The taxpayer will need to provide documentation and/or testimony that justifies its return position.

Conclusion

The IRS examination process is somewhat of a pyramid.  The bottom is the largest group and consists of returns that are filed and never examined; the next level up is those that are examined and resolved at audit; above that are those resolved at IRS Appeals; and finally, at the top, are the cases that are litigated.  The path to resolution is influenced by how the examination is managed from the outset and how information is presented.