T&E Substantiation

In Townsend Industries, Inc., 342 F3d 890 (8th Cir. 2003), the Eighth Circuit reversed and remanded a district court decision (SD IA, 8/21/02). The case debated the inclusion of the cost of a company’s annual fishing trip in employee compensation. The Eighth Circuit ruled that the trip’s cost was a Sec. 132 working-condition fringe benefit and qualified as a business expense under Secs. 162 and 274.

Facts

Townsend Industries, Inc. was founded in the 1950s by Robert Townsend, its sole shareholder and president. The company’s main product was the T-51 printing press attachment, which printed documents in more than one color. It was produced at a factory located at the company headquarters in Altoona, IA, and sold nationally and internationally.

Each June, the company held a meeting for its sales personnel at its Altoona headquarters, followed by a four-day fishing trip at a five-star resort in Ontario, Canada. The trip was for all sales personnel and factory employees, but not their spouses and children.

During the year, there was not much contact between the two groups. Even at the annual sales meeting, there was very limited participation by factory employees. Thus, the trip’s purpose was to encourage business discussions, by bringing sales personnel and factory employees together in a comfortable and pleasant setting.

Although factory employees were encouraged to go on the trips, attendance was not mandatory. Those who did attend received their regular pay for that week. Employees who did not go worked their regular hours or took a vacation. Typically, more than half the employees attended the fishing trip.

Employees testified that although the trip was enjoyable, it was considered as part of their job. Further, company business was discussed from one to four hours per day. The “discussions took place on the bus trips, at meals, on boats, and in cabins.” To encourage these discussions, boat and cabin assignments placed specific individuals together.

Activities and schedules were somewhat flexible, although there was one banquet and motivational speech. Although most of the participants fished, they could also play golf or go hiking. Cabin and boat assignments could be changed for any reason. Nonetheless, there was substantial testimony from employees that the business discussions on the fishing trip not only improved their job performance, but also were important in solving specific product problems. Contemporaneous, written evidence of the business purpose of the discussions, however, was negligible.

In 1996 and 1997, the IRS challenged the taxpayer’s treatment of the trip-related cost, contending that it “constituted wages upon which taxes should have been paid.” It assessed additional employment taxes for those years. The taxpayer paid a small part of the assessment and sued for a refund.

Law

Under Sec. 132, working-condition fringes can be excluded from employee gross income. This benefit results when employees are provided with property or a service that they could have deducted under Sec. 162 had they paid for it themselves. Sec. 162 allows a deduction for the ordinary and necessary expenses of carrying on a trade or business.

However, Sec. 274 imposes additional requirements on the deductibil-ity of business expenses. First, under Sec. 274(a)(1)(A), an entertainment expense is deductible if it is “directly related” or “associated with” the active conduct of the taxpayer’s trade or business. Second, Sec. 274(d) requires that any item deducted under Sec. 162 for travel or entertainment (T&E) must be substantiated. Substantiation consists of records or other evidence supporting the taxpayer’s statements as to the amount, time, place and business purpose of the expense, as well as the business relationship between the taxpayer and the persons entertained.

Finally, Regs. Sec. 1.274-2(c)(3) imposes four additional requirements for deducting related T&E expenses. They require:

1. The taxpayer to have “more than a general expectation” of gaining some business benefit;

2. The taxpayer to engage in some business activity, other than entertainment, to obtain such business benefit;

3. The “principal character or aspect” of the combined business and entertainment to be business (hunting or fishing trips are not considered business, unless clearly established to the contrary); and

4. The expenditure to be attributable to the taxpayer and its employees and the others actually conducting business.

Decisions

District court: The district court sided with the Service, ruling that the costs of the fishing trips were taxable wages, and not working-condition fringe benefits. Primarily, it decided that the costs did not qualify as ordinary and necessary business expenses under Sec. 162; the meetings were voluntary, and there seemed to be no real connection between them and the fishing trip.

It also ruled that the fishing trip expenses were neither directly related nor associated with the active conduct of the taxpayer’s business, as required under Sec. 274(a)(1)(A). It found the principal character or aspect of the fishing trips not to be the conduct of business. “Townsend basically held an expectation to derive uncertain future benefits, particularly in the way of improved comradery and relations among its employees and sales personnel, from the fishing trip.” The court concluded that such an expectation was not sufficiently directly related. Similarly, it found the fishing trip and the sales meeting to be too disparate in time to qualify as associated with the entertainment expense.

Finally, it found the costs to be inadequately substantiated; Townsend did not provide adequate records supporting the trips’ business purpose. “[T]here was not sufficient evidence presented to indicate exactly what the business discussions entailed and whether the discussions noted actually occurred in 1996, 1997, or in some other identifiable year. The testimony at trial indicated that all of the fishing trips ‘run together’ because so many of the participants have attended for many years.” The testimony “lacked the necessary specificity” regarding the business conversations on the trips.

Eighth Circuit: The Eighth Circuit disagreed on all counts. It concluded, “the trips and their expenses qualified as working condition fringe benefits under 132 and a bona fide business expense under 162 and 274 of the Internal Revenue Code.” Contrary to the district court, the Eighth Circuit found, “Townsend had a realistic expectation to gain concrete future benefits from the trip based on its knowledge of its own small company, its knowledge of the utility of interpersonal interactions that probably would not occur but for the trip, and its knowledge of its own past experience.”

The voluntary nature of the trips was consistent with the owner’s philosophy and methods of running the business. While employees were not required to attend, they did receive strong encouragement and clearly felt an obligation to attend as part of their jobs. More importantly, numerous witnesses testified about specific business issues discussed and problems solved during the 1996 and 1997 trips. While there was little contemporaneous written evidence to rely on, the court found “the business nature of the trip was well established by the witnesses who testified both for and against Townsend.” Adequate substantiation was provided “in the form of its ‘own statement[s]...containing specific information in detail [and] [b]y other corroborative evidence sufficient to establish’ the business nature of the expense.”

Conclusion

The difference in the courts’ decisions stems from a difference in the interpretation of the facts. Both seemed to apply the same standards. The district court found the taxpayer’s statements and other evidence insufficient to substantiate an entertainment-related business expense; the Eighth Circuit found otherwise. Nonetheless, the decision should not give comfort to taxpayers with lax recordkeeping. The Eighth Circuit did not lower the bar—the taxpayer’s position was supported by substantial testimony. The case’s significance is in its illustration of the importance of substantiation. The interpretation of facts is subjective and sometimes arbitrary. Contemporaneous, written evidence is critical to ensure a deduction for entertainment expenses, unless taxpayers are willing to go the expensive litigation route to prove their case.

From Wayne M. Schell, Ph.D., CPA, Christopher Newport University, Newport News, VA (Not affiliated with BDO Seidman, LLP)