United States

Clothing allowances provided to employees are not always in fashion

IRS regulations guide treatment of qualified employee discounts


Clothing discounts are a benefit often offered by fashion companies and retailers to their employees. Whether companies attract young, hip professionals who love the brand and enjoy wearing the clothing on the sales floor, or represent a more traditional brand, where the discount is an added benefit to employees, there are true advantages, as well as complexities resulting from this practice.

For potential fashion-forward employees, these trendsetters dream of being the first of their friends to wear clothes straight off the runway or showroom. And most fashion companies want to have their employees, especially salespeople, model the latest season’s fashions during Market Week, when the retail buyers are present, and throughout the year, as key ambassadors of the brand. To aid in this effort, many companies provide clothing allowances to their employees, giving each a set amount per year for which they can obtain the designer’s products at no cost, while others provide employees steep discounts off wholesale prices for clothing and merchandise. Unfortunately, very often, both employer and employee are blind to the tax implications of these benefits.

Qualified employee discount

In some cases, it is acceptable to sell products to employees at a discount. IRS regulations provide that gross income of an employee does not include the value of a qualified employee discount. A qualified employee discount is an employee discount with respect to qualified property or services provided by an employer to an employee for use by the employee to the extent the discount does not exceed the gross profit percentage multiplied by the price at which the property is offered to customers in the ordinary course of the employer's line of business.

Qualified property means any property that is offered for sale to customers in the ordinary course of the line of business of the employer in which the employee performs substantial services. The term qualified property or services does not include any property or services of a kind that is not offered for sale to customers in the ordinary course of the line of business of the employer. For example, employee discounts provided on property offered to employees and their families, such as merchandise sold at an employee store or through an employer-provided website or catalog service, may not be excluded from gross income. Also noteworthy is the nondiscrimination rule, which indicates the exclusion for a qualified employee discount applies to highly compensated employees only if the discount is available on substantially the same terms to each member of a group of employees that is defined under a reasonable classification set up by the employer that does not discriminate in favor of highly compensated employees.


The IRS provides guidance in calculating the gross profit percentage, which is the excess of the aggregate sales price for merchandise sold by the employer in a particular line of business over the aggregate cost of such merchandise to the employer divided by the aggregate sales price. An example of this includes the following:

Total sales for a line of clothing was $1 million, and the employer’s cost for the merchandise was $600,000. The gross profit percentage would be 40 percent calculated as follows: ($1,000,000 – $600,000)/$1,000,000. Apply this to the example below.

An employer sells a garment to customers for $1,000. The gross profit percentage, as calculated above, equals 40 percent. If an employee is offered a discount of up to 40 percent on this garment (in this case, $400 on an item selling for $1,000) the employee would not have reportable income. If the employee is offered a discount in excess of $400, the employee would have reportable income to the extent of the excess, and the employer would be required to include such excess on the employee’s Form W-2.

In determining the amount of an employee discount, the price at which the property or service is being offered to customers at the time of the employee's purchase is controlling. Assume an employer offers a product to customers for $200 during the last six months of a calendar year (perhaps to discounters after the season is over), but at the time the employee purchases the product at a discount, the price at which the product is being offered to customers is $250. In this case, the price from which the employee discount is measured is $250.

The gross profit percentage must be calculated separately for each line of business, based on the aggregate sales price and aggregate cost of property in that line of business for a representative period. One possibility would be to use the taxable year immediately preceding the taxable year in which the discount is available. An employer, in its first year of existence, may estimate the gross profit percentage of a line of business, based on its markup from cost. Alternatively, an employer in its first year of existence may determine the gross profit percentage by reference to an appropriate industry average.


It is important to understand the consequences of providing a set amount of clothing allowance to your employees for which they pay nothing. In the example provided above, the employee will need to pay taxes on at least a portion of the benefit. However, there are ways you can provide employees with discounts that are not taxable. The terms of the plan should be in writing and applied uniformly. The plan should be monitored and updated, and the timing of offered discounts should be aligned with the changing sales price to customers throughout the year. It is important that employers make these rules clear to their employees and explain the tax consequences, if any. It is acceptable for businesses to offer employees a discount on their products, but not a best practice to merely give the products away without understanding or anticipating the potential impact on employee compensation.

Originally published January 2016, reviewed August 2018

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