New IRS Focus on Fringe Benefits

The IRS continues to consider examination of executive compensation a top priority. Begun a few years ago with a review of two dozen large corporations, this initiative has been extended to include every large and mid-size business under examination. Examiners focus on those issues which most would agree are significant and often highly complex, such as stock-based compensation, the million-dollar cap on compensation and golden parachute payments. However, it is often the review of a business’s fringe-benefit programs, including executive perks, that causes the greatest frustration and conflict for both the taxpayer and the IRS.

Many agents have begun using a pro-forma employment tax questionnaire geared toward determining which fringes are provided to which employees and how the business treated the fringes for purposes of Federal employment taxes and income tax withholding. The questionnaire is quite extensive; it includes a list of the most common perks and instructs the business to identify any other employee fringes that have not been addressed specifically. Businesses are finding the examination’s scope, which begins as a review of executive compensation programs, can quickly unfold into issues that affect rank-and-file employees as well. Given the IRS’s scrutiny, businesses should take a fresh look at their fringe-benefit programs.

At first blush, the rules concerning fringe benefits seem straightforward. Any analysis begins with the explicit statement in Sec. 61(a) asserting that gross income includes “compensation for services, including…fringe benefits” except as otherwise specifically excluded by another Code provision. Generally, the fair market value (FMV) of a taxable fringe benefit provided to an employee is subject to employment taxes and must be reported on Form W-2.

The Code and regulations identify several perks that, if satisfying the specific conditions prescribed therein, can be provided tax free to business employees. These include reimbursements for adoption assistance (Sec. 137), education expenses (Sec. 127) and dependent care expenses (Sec. 129). If no specific Code exclusion applies, the fringe benefit may still be eligible for exclusion pursuant to the four broad categories of excludible fringes listed in Sec. 132. Two of these—working condition fringe benefits and de minimis fringe benefits—are often relied on by businesses to treat various benefits as tax free.

Working Condition Fringe Benefits

Sec. 132(d) provides an exclusion for any property or service provided to an employee to the extent that, if the employee paid for the property or service, such payment would be allowable as a deduction under Sec. 162 (trade or business expenses) or 167 (depreciation). There are three basic requirements for a working condition fringe to qualify for exclusion:

1. The employee’s use of the property or service must relate to the employer’s trade or business;

2. The employee would have been entitled to a business expense deduction if the property or services that were provided by the employer had been purchased by the employee; and

3. The employee must maintain the required records (including the requirements of Sec. 274) with respect to the business use of the property or services provided by the employer.

These apparently straightforward rules can be quite difficult to apply. For example, if the requirements for deductibility under Sec. 162 are met, computers provided to employees for home use may qualify as an excludible working condition fringe. However, like business-provided cars, computers are “listed” property under Sec. 280F and are subject to special documentation rules that require an allocation between business and personal use. In this instance, business use is determined by dividing the number of hours the computer is used for business purposes during the year by the total number of hours that the computer is used during the year. The value of personal use is includible in employee income and subject to withholding, unless it is excludible as a de minimis fringe benefit.

De Minimis Fringe Benefits

Sec. 132(e)(1) provides an exclusion for any property or service, the value of which (after taking into account the frequency with which similar fringes are provided by the employer to the employer’s employees) is so small as to make accounting for it unreasonable or administratively impracticable.

Except for occasional meal money or local transportation fare, cash—no matter how small in amount—is never excludible as a de minimis fringe. A cash-equivalent fringe benefit (a gift certificate or credit card) is not excludible, even if the same property or service acquired (if provided in kind) would be excludible. If a benefit is not de minimis because it exceeds either the value or frequency limits, the entire benefit is included in the employee’s income.

Regs. Sec. 1.132-6(e)(1) provides examples of de minimis fringes, including occasional personal use of a business copying machine; occasional parties or picnics for employees and their guests; occasional meals, meal money or local transportation fare provided to enable the employee to work overtime; holiday gifts of property with a low FMV; and occasional tickets for entertainment events.

Additionally, Regs. Sec. 1.132-6(e)(2) provides specific examples of benefits that are not excludible as de minimis fringes. These include season tickets to sporting or theatrical events; the commuting use of the employer’s car more than once a month; memberships in a private country club or athletic facility, regardless of the employee’s frequency of use; and use of the employer’s apartment, hunting lodge, boat, etc., for a weekend.

As with working condition fringes, the application of the de minimis fringe rules can be difficult. For example, while the IRS has not provided a dollar threshold for meeting the de minimis requirement, Field Service Advice 200219005 indicates that the smaller in value and less frequently a particular benefit is provided, the more likely it will qualify as de minimis. Chief Counsel Advice 200108042 held that nonmonetary achievement awards with a $100 FMV would not qualify as de minimis fringes and, consequently, would be wages.

Technical Advice Memorandum 200437030 discusses the question of administrable impracticality in an evaluation of how gift certificates should be treated. The IRS ruled that an employer that switched from giving employees an annual holiday ham, turkey or gift basket to giving $35 gift coupons redeemable at specified food stores had to treat the coupons as taxable wages. The IRS was not persuaded that it was administratively impracticable for the business to account properly for an employer-provided holiday gift coupon. Similarly, in American Airlines, 40 Fed. Cl. 712 (1998), aff’d, 204 F3d 1103 (Fed Cir. 2000), an employer’s issuance of American Express restaurant credit-card vouchers were held to have “cash equivalent benefit” and did not qualify as de minimis fringe benefits.

Conclusion

The IRS’s increased focus on fringe benefits should motivate businesses to take a closer look at policies and procedures around these issues. A well-documented policy, along with some evidence of program oversight, often can go a long way in convincing an agent that the business is substantively compliant and just may help to curtail an otherwise protracted examination.

From Kathleen Mort, CPA, Pittsburgh, PA