How to Tax Gift Cards in Payroll

Giving your employees a gift card is a great way to show appreciation, but it creates a tax question you can't ignore. While it feels like a simple gift, the IRS views most gift cards as a cash equivalent, making them taxable income for the recipient. This article will walk you through exactly how to classify gift cards and process them correctly in your payroll to ensure you stay compliant.

Are Gift Cards Taxable Income? The Short Answer is Almost Always Yes

The Internal Revenue Code states that all forms of compensation are taxable unless specifically excluded. Many business owners hope gift cards fall under the exclusion for de minimis (minimal) fringe benefits. However, that’s rarely the case.

A de minimis benefit is any property or service you provide to an employee that has so little value that accounting for it would be unreasonable or administratively impractical. Think of a holiday turkey, a bouquet of flowers, or occasional coffee and donuts. The key factor is not just the small value, but the difficulty in tracking it.

Gift cards fail this test. According to IRS Publication 15-B, cash and cash equivalents, which include gift cards, can never be considered de minimis benefits, regardless of their amount. Even a $10 gift card is considered taxable. The logic is simple: a gift card has a readily ascertainable cash value, making it easy to account for. Gifting a $50 VISA gift card is essentially the same as giving an employee $50 in cash in the eyes of the IRS.

Common Misconceptions About Gift Card Taxes

Many well-intentioned employers make mistakes based on a few common myths. Let's clear them up:

• "It's under $25, so it's not taxable." The dollar amount does not change the classification. If an item is a cash equivalent, its value is taxable, period.
• "It's a gift, not a bonus." Your intent doesn't change the tax treatment. Unless it qualifies for a specific exemption (which is rare for employee gifts), the IRS considers it compensation.
• "It's for a specific store, not cash." Restricting how the funds can be spent doesn't remove its cash-like nature. The card still has a clear, reportable monetary value.

The bottom line is clear: if you give an employee a gift card, you must report its value as income and withhold taxes on it.

Step-by-Step Guide: How to Tax Gift Cards in Payroll

Since gift cards are taxable income, they must be processed through your payroll system. They are classified as supplemental wages—payments made to an employee outside of their regular salary or hourly pay. This category includes bonuses, commissions, and awards. Proper classification is key because it determines how you withhold taxes.

Step 1: Calculate the Taxable Amount (Consider a "Gross-Up")

Let's say you want an employee to receive a gift card worth exactly $100. If you simply add $100 to their paycheck, they won't end up with $100 after taxes. FICA (Social Security and Medicare) and federal and state income taxes will be withheld, reducing the net amount.

To ensure your employee gets the full intended value, you can "gross-up" the payment. This means you calculate a higher gross amount so that after taxes, the net payment equals the gift card's value. You are essentially paying the employee's share of the taxes on the gift.

Here’s a simplified example of how to calculate the gross-up amount:

1. Sum the tax rates:
   • Federal supplemental wage rate: 22%
   • Social Security: 6.2%
   • Medicare: 1.45%
   • State supplemental rate (will vary; let’s use 5% for this example)
   • Total Tax Rate: 22% + 6.2% + 1.45% + 5% = 34.65%
2. Use the Gross-Up Formula: Gross Payment = Desired Net Pay / (1 - Total Tax Rate)
3. Calculate: Gross Payment = $100 / (1 - 0.3465) = $100 / 0.6535 = $153.02

In this scenario, you must add $153.02 to the employee's payroll. After $53.02 in taxes are withheld, they have "paid" for the $100 gift card, and their regular take-home pay is unaffected. Grossing up is a generous gesture recognized by employees, though not required.

Step 2: Withhold Payroll Taxes

As supplemental wages, gift card values are subject to standard payroll taxes:

• Federal income tax
• Social Security and Medicare taxes (FICA)
• State and local income taxes (where applicable)

You have two primary methods for withholding federal income tax on supplemental wages.

The Percentage Method

This is the simplest and most common approach. You withhold a flat 22% for federal income tax on the supplemental payment (for aggregate supplemental wages up to $1 million in a year). You still need to withhold the standard 6.2% for Social Security and 1.45% for Medicare, as well as any mandatory state and local taxes.

The Aggregate Method

Under this method, you combine the gift card value with the employee's regular wages for the current payroll period. Then, you calculate the federal income tax withholding based on the employee's Form W-4 elections as if the total amount were a single regular payment. This method often results in a different tax-withholding amount but aligns more closely with the employee's actual income bracket.

Most modern payroll software, such as QuickBooks Payroll or Gusto, can handle both supplemental wage calculation methods easily.

Step 3: Process in Your Next Payroll Run

The physical gift card is given to the employee separately, but its monetary value must be processed through your formal payroll system. To document the process correctly:

1. Create a specific earnings code in your payroll software (e.g., "Gift Card," "Taxable Award").
2. Add the gift card's value (either the face value or the grossed-up amount) to the employee's paycheck for the next pay period.
3. The payroll system will then automatically calculate and deduct the appropriate taxes.
4. Let the employee know beforehand that this will appear on their next pay stub so they aren't surprised by the increased gross wages and tax withholdings.

Remember, the employer must also pay its matching share of FICA taxes (7.65%) on the gift card's value.

Reporting Gift Cards on Year-End W-2 Forms

Properly processing the gift card through payroll ensures it is automatically and accurately reported on the employee's year-end Form W-2. The taxable value of the gift card is included with other earnings in the following boxes:

• Box 1: Wages, tips, other compensation
• Box 3: Social Security wages
• Box 5: Medicare wages and tips
• Box 16: State wages, tips, etc. (if applicable)

There is no separate reporting specifically for gift cards on the W-2. The value is simply rolled into the employee's total taxable earnings for the year, ensuring their tax documents match what the IRS has on record.

What Are Some Non-Taxable Alternatives?

If your goal is to provide a reward without creating a tax liability for your team, you'll need to stay within the strict rules for de minimis benefits. The gift must be occasional, of low value, and impractical to account for. Examples that generally qualify include:

• A ham, turkey, or other similar nominal item of personal property for a holiday.
• Occasional tickets to a theater or sporting event.
• Flowers or fruit for special circumstances.
• Company-branded merchandise (e.g., a shirt or coffee mug.)

Another option for tax-free awards is through a formal employee achievement award program. Under IRC Section 274(j), these awards must be tangible personal property (not cash or gift cards), presented as part of a meaningful program for safety or length of service, and not be a form of disguised compensation. These programs have specific rules and dollar limits, making them more complex to administer than a simple holiday gift.

Final Thoughts

While gift cards are a convenient and popular way to reward employees, they are nearly always considered taxable compensation by the IRS. Proper handling requires adding the gift card’s full value to payroll, withholding all relevant taxes just as you would for a bonus, and ensuring the amount is included in the employee’s final W-2 wages.

Running payroll correctly demands precision, and a single misstep can lead to compliance issues. When you have questions about fringe benefits, supplemental wages, or a specific IRC section, researching the answer takes time. We built Feather AI to eliminate that lengthy process. You can ask complex tax questions in plain English and get an instant, citation-backed answer, giving you the confidence to manage employee compensation accurately.