Tax Reform Proposals Advance in the House and Senate

Yesterday, the full House passed its tax reform proposal, the Tax Cuts and Jobs Act (H.R. 1), on a party-line vote, 227-205.  In addition to the headline changes to the corporate and individual tax systems, the bill would make numerous changes to various fringe benefit exclusions, employer deductions for fringe benefits and executive compensation, cross-border withholding and sourcing, and employee retirement plans  (discussed here, here, here, herehere, here, and here).  Meanwhile, the Senate Finance Committee advanced its tax reform proposal, also on a party-line vote (14-12), with similar changes (discussed here and here).

Before advancing the proposal to the floor, the Senate Finance Committee adopted additional modifications to its existing proposal.  The new modifications included a change to the transition rule for the modified deduction limitation for executive compensation, a delay in the effective date of the new deduction disallowance for meals provided at the convenience of the employer and excluded from employee’s income under Code section 119 or 132(e)(6), and a definition of Mississippi River Delta flood disaster area and Mississippi River Delta flooding distribution for purposes of the retirement plan relief provided in the existing proposal:

  • The new transition relief for the deduction limitation under Code section 162(m) would apply the changes made in the proposal only to contracts entered into after November 2, 2017, and contracts materially modified after that date. The relief provided in the first modification to the chairman’s mark would have applied only if the compensation was no longer subject to a substantial risk of forfeiture before 2017.
  • The modification would delay the effective date for the deduction disallowance for meals provided for the employer’s convenience and meals provided at employer-operated eating facilities until 2026.
  • The modification defines “Mississippi River Delta flood disaster area” as an area subject to a Presidential major disaster declaration before March 31, 2016, by reason of severe storms and flooding occurring in Louisiana, Texas, and Mississippi during March 2016. A “Mississippi River Delta flooding distribution” is a distribution from an eligible retirement plan made on or after March 1, 2016, and before January 1, 2018, to an individual whose principal residence on March 1, 2016, was located in the Mississippi River Delta flood disaster area and who sustained an economic loss by reason of the severe storms and flooding that resulted in the Presidential disaster declarations.  (The modification also provides for an enhanced ability to claim a casualty loss deduction as a result of such storms and flooding.)

Impact of Tax Cuts and Jobs Act: Part II – Deduction Disallowances for Entertainment Expenses and Certain Fringe Benefits

Yesterday, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  This is the second in a series of posts discussing the effect of the Bill on topics of interest to our readers.  (See our first post discussing the effect of the Bill on various exclusions for employer-provided benefits here.)  Section 3307 of the Bill makes several changes to the deduction limitations under section 274 related to meals and entertainment expenses.  The Bill also expands the reach of the deduction limitations to disallow deductions for de minimis fringe benefits excluded from income under Code section 132(e), unless the employer includes such amounts in the employee’s taxable income. With respect to tax-exempt entities, section 3308 of the Bill would treat funds used to provide employees transportation fringe benefits and on-premises gyms and other athletic facilities as unrelated business taxable income.

Total Disallowance of Deductions for Entertainment Expenses.  Under Code section 274(a), a taxpayer may not deduct expenses for entertainment, amusement, or recreation (“entertainment expenses”), unless the taxpayer establishes that the item was directly related to the active conduct of the taxpayer’s business, subject to a number of exceptions in Code section 274(e) (e.g., reimbursed expenses; expenses treated as compensation to (or included in the gross income of) the recipient; recreational, social, and similar activities primarily for the benefit of employees other than highly compensated employees; entertainment sold to customers).  If the taxpayer establishes that the entertainment expenses were directly related to the active conduct of its trade or business, section 274(n) limits the deduction to 50 percent of expenses relating to entertainment, subject to a number of exceptions, many of which are the same exceptions that apply to the 100 percent disallowance under Code section 274(a) (e.g., reimbursed expenses; expenses treated as compensation to (or included in the gross income of) the recipient; recreational, social, and similar activities primarily for the benefit of employees other than highly compensated employees; entertainment sold to customer).

The Bill would amend section 274(a) to eliminate the exception for entertainment expenses directly related to the active conduct of the taxpayer’s business.  Accordingly, deductions for entertainment expenses would be fully disallowed unless one of the exceptions under Code section 274(e) applies.  The Bill would also make changes to some of the exceptions under Code section 274(e), described below.

Disallowance of Deductions for On-Site Athletic Facilities.  Similarly, the Bill would fully disallow a deduction for on-site gyms or athletic facilities as defined in Code section 132(j)(4)(B).  Such facilities are gyms and athletic facilities that are located on the premises of the employer, operated by the employer, and substantially all the use of which is by employees of the employer, their spouses, and their dependent children.  Although the Bill would add such expenses to the list of disallowed deductions under Code section 274(a), the Bill does not eliminate the exclusion from employee’s income under Code section 132.  Accordingly, employers will be left to choose between (1) losing the deduction for the cost of such facility or (2) retaining the deduction by imputing the fair market value of the use of the facility to employees. The Bill includes instructions to the Treasury Department to issue regulations providing appropriate rules for allocation of depreciation and other costs associated with an on-site athletic facility.

Disallowance of Deductions for Qualified Transportation Fringes and Parking Facilities.  The Bill would also fully disallow a deduction for qualified transportation fringes as defined in Code section 132(f) and parking facilities used in connection with qualified parking as defined in Code section 132(f)(5)(C).  These fringe benefits are popular with employees and permit employees to either pay for an employee’s public transportation, van pool, bicycle, or parking expenses related to commuting on a pre-tax basis or allow employees to elect to receive a portion of their compensation in the form of non-taxable commuting benefits.  Like with athletic facility expenses, the Bill would add such expenses to the list of disallowed deductions under Code section 274(a), but retain the exclusion from employee’s income under Code section 132.  As a result, employers will be left to choose between (1) losing the deduction for the cost of providing these benefits or (2) discontinuing the benefits.  The Bill includes instructions to the Treasury Department to issue regulations providing appropriate rules for allocation of depreciation and other costs associated with a parking facility.

Disallowance of Deductions for Certain De Minimis Fringe Benefits.  The Bill would likewise disallow deductions for what it refers to as “amenities.”  Amenity is defined as a de minimis fringe benefit that is primarily personal in nature and involving property or services that are not directly related to the taxpayer’s business.  This would seemingly subject expenses related to the provision of most de minimis fringe benefits to a full deduction disallowance unless the expense qualified for one of the exceptions under Code section 274(e) (e.g., expenses for food and beverages (and facilities used in connection therewith) furnished on the business premises of an employer primarily for its employees; reimbursed expenses; expenses treated as compensation to (or included in the gross income of) the recipient; recreational, social, and similar activities primarily for the benefit of employees other than highly compensated employees; items available to the public; entertainment sold to customers).  It would perhaps leave unaffected some de minimis fringe benefits such as personal use of a copy machine.  Even with respect to de minimis fringe benefits that would likely qualify as amenities, it is unclear how much of an impact this would have, because many de minimis fringe benefits would likely qualify for one of the exceptions (for example, coffee, doughnuts, soft drinks, and occasional cocktail parties would likely remain fully deductible under Code sections 274(e)(1) and 274(n)(2)(B), provided they are provided to employees on the business premises of the employer).  Others, however, such as occasional sporting or theater tickets, gifts given on account of illness, and traditional holiday or birthday gifts, may well be affected by the disallowance.  The Bill includes instructions to the Treasury Department to define amenity in regulations.

Deduction Limited to Amounts Actually Included in Income.Code section 274(e)(2) contains an exception to the disallowance under Code section 274(a) to the extent an expense is treated as compensation to an employee.  Code section 274(e)(9) includes a similar provision for expenses treated as includible in the gross income of the recipient that is not an employee of the taxpayer as compensation or as a prize or award.  The Bill would limit the exception for entertainment expenses treated as compensation to (or included in the gross income of) the recipient to the amount actually treated as compensation (or included in gross income of) the recipient as it is with employees that are “specified individuals” under current law.  Code section 274(e)(2)(B) was adopted to impose this limitation with respect to certain senior executives following the decision in Sutherland Lumber-Southwest, Inc. v. Commissioner.  The Bill would extend the effect of Code section 274(e)(2)(B) to all recipients.  The limitation prevents a taxpayer from deducting a cost in excess of the amount required to be included in the recipients income, such as in the case of vacation travel on board corporate aircraft, where the cost of operating the flight often far exceeds the amount required to be included in the employee’s income under Treasury Regulations.

Deduction Disallowance Applies with Respect to Expenses Reimbursed by a Tax-Exempt Entity.  Under section 274(e)(3), a taxpayer that incurs an expense subject to the deduction disallowance in section 274(a) or 274(n) may fully deduct the expense if the expense is reimbursed by another party, provided that certain requirements are met.  The rule allows two parties as part of a reimbursement arrangement to effectively shift the burden of the deduction disallowance to the party between them.   Section 3307 of the Bill amends section 274(e)(3) to prevent the use of tax-exempt entity (that is not affected by the deduction disallowance under current law) to avoid the effect of the disallowance.

Full Deduction for Meals Excluded from Employee’s Income under Code Section 119.  Under Code section 119, the value of meals provided to employees for the convenience of the employer are excludable from the employee’s income.  Such meals, however, are currently subject to the 50% deduction disallowance under Code section 274(n) unless the meals are treated as being provided at an employer-operated eating facility that is a de minimis fringe benefit under Treasury Regulation § 1.132-7.  (This was the issue in the Boston Bruins decision (earlier coverage).)  Running counter to the general approach of the legislation—which seeks to eliminate corporate deductions for amounts not included in employee income—the Bill would amend Code section 274(n)(2)(B) include meals excludable from an employee’s income under section 119 in addition to amounts being excludable under section 132(e).  This change would appear to expand the ability of employer’s to fully deduct more meals provided to their employees.

With the exception of the last change, the Bill would seek to limit the ability of taxpayers to deduct entertainment expenses and expenses related to the provision of various excludable fringe benefits.  The provisions would be effective for amounts paid or incurred after December 31, 2017.

Impact of Tax Cuts and Jobs Act: Part I – Exclusions for Certain Employer-Provided Benefits

Today, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We will release a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  In the first of this series of posts, we will discuss the Bill’s potential impact on the exclusions for several popular employer-provided benefits.

Limitation on Exclusion for Employer-Provided Meals and Lodging. Under Code section 119 as currently written, the value of employer-provided housing is excludable from an employee’s gross income and is not considered to be wages for purposes of employer withholding.  Section 1401 of the Bill would add a new subsection (e) to Code section 119 to limit the income exclusion for employer-provided housing to $50,000 ($25,000 for a married individual filing a joint return), and that amount would phase out for highly compensated individuals.  Presumably, this change would obligate employers to report the fair market value of employer-provided housing on an employee’s Form W-2 even if excludable under Code section 119, and the employee would take the exclusion on his or her individual income tax return.  In addition, the exclusion would be limited to a single residence for all employees, and the exclusion would be altogether eliminated for 5 percent owners of the employer.

Elimination of Exclusion for Dependent Care Assistance Programs. Under Code section 129, the value of employer-provided dependent care assistance programs (“DCAP”) is generally excluded from an employee’s income and wages up to $5,000 per year.  Employees typically take advantage of this exclusion through a dependent care flexible spending account that is part of a cafeteria plan under Code section 125.  Section 1404 of the Bill would repeal this exclusion in its entirety. Note: This provision was eliminated from the bill by an amendment adopted by the Ways and Means Committee (discussed here).

Educational Assistance Programs and Qualified Tuition Reductions. Two benefits primarily focused on assisting employees with educational expenses would be eliminated by the Bill.  First, under Code section 127, amounts paid to or on behalf of an employee under a qualified educational assistance program are excluded from an employee’s income and wages up to $5,250 per year.  Section 1204 of the Bill would repeal this exclusion in its entirety.  Second, the exclusion from income and wages for qualified tuition reductions provided by educational institutions would also be repealed by Section 1204.  Though this change would affect fewer employers, it would eliminate an often-significant benefit for employees who work for educational institutions, as they would be taxed on the full amount of tuition waived for them or their spouses or dependents to attend the educational institution.

Elimination of Exclusion for Adoption Assistance Programs. Currently, Code section 137 provides an exclusion from an employee’s income and wages for amounts provided by an employer to an employee for amounts paid or expenses incurred for the adoption of a child up a certain amount that is indexed for inflation ($13,570 in 2017).  Section 1406 of the Bill would repeal the exclusion.

Elimination of Exclusion for Employer-Paid Moving Expenses. Code section 132(a)(6) provides an exclusion from income and wages for a qualified moving expense reimbursement, which is an employer-provided benefit capped at the amount deductible by the individual if he or she directly paid or incurred the cost.  Section 1405 of the Bill would repeal this exclusion.

Exclusion for Employee Achievement Awards. Code section 74(c) excludes the value of certain employee achievement awards given in recognition of an employee’s length of service or safety achievement from the employee’s income. Section 274(j) limits an employer’s deduction for employee achievement awards for any employee in any year to $1,600 for qualified plan awards and $400 otherwise. A qualified plan award is an employee achievement award that is part of an established written program of the employer, which does not discriminate in favor of highly compensated employees, and under which the average award (not counting those of nominal value) does not exceed $400.  The exclusion under Code section 74(c) is limited to the amount that the employer is permitted to deduct for the award.  Section 1403 of the Bill would repeal this exclusion and the corresponding deduction limitation.

All of these changes would be effective for tax years beginning after 2017.  In addition to the employer-provided benefits discussed in this post, the Bill would affect a number of other topics covered by this Blog, so stay tuned for Part II in the series.

Tax Court Expands Section 119 Exclusion in Boston Bruins Decision

In a much anticipated decision, the U.S. Tax Court ruled yesterday that “the business premises of the employer” can include an off-premises facility leased by the employer when its employees are on the road.  The decision in Jacobs v. Commissioner addressed whether the employer (in this case, the professional hockey team, the Boston Bruins) was entitled to a full deduction for the meals provided to the team and staff while on the road for away games.  The debate arose after the IRS challenged the full deduction and asserted that the employer should have applied the 50% deduction disallowance applicable to meals by section 274(n) of the Code.

Under section 162 of the Code, an employer may deduct all ordinary and necessary business expenses.  However, in recognition that the cost of meals is inherently personal, the Code limits the deductions for most business meal expenses to 50% of the actual expense under section 274(n), subject to certain exceptions.  The exception at issue in Jacobs allows an employer to deduct the full cost of meals that qualify as de minimis fringe benefits under section 132(e) of the Code.  In general, this includes occasional group meals, but would not typically include frequently scheduled meals for employees travelling away from home.  (For this purpose, home is the employee’s tax home, which is typically the general area around the employee’s principal place of employment.)  However, under Treasury Regulation § 1.132-7, an employer-operated eating facility may qualify as a de minimis fringe benefit if, on an annual basis, the revenue from the facility is at least as much as the direct operating cost of the facility.  In other words, an employer may subsidize the cost of food provided in a company cafeteria, provided the cafeteria covers its own direct costs on an annual basis and meets other criteria (owned or leased by the employer, operated by the employer, located on or near the business premises of the employer, and provides meals immediately before, during, or immediately after an employee’s workday).

The Bruins’ owners argued that they were entitled to a full deduction because the banquet rooms in which employees were provided free meals qualified as an employer-operated eating facility.  That may leave some of our readers wondering, “How can a facility that is free have revenue that covers its direct operating cost?”  The key to answering that question lies in the magic found in the interface of sections 132(e)(2)(B) and section 119(b)(4) of the Code.  Under section 132(e)(2)(B), an employee is deemed to have paid an amount for the meal equal to the direct operating cost attributable to the meal if the value of the meal is excludable from the employee’s income under section 119 (meals furnished for the “convenience of the employer”) for purposes of determining whether an employer-operated eating facility covers its direct operating cost.  In turn, section 119(b)(4) provides that if more than half of the employees who are furnished meals for the convenience of the employer, all of the employees are treated as having been provided for the convenience of the employer.  Working together, if more than half the employees are provided meals for the convenience of the employer at an employer-operated eating facility, the employer may treat the eating facility as a de minimis fringe benefit, and deduct the full cost of such facility.

The IRS objected to the owners’ treatment of the banquet rooms as their employer-operated eating facilities and disallowed 50% of the meal costs.  The Tax Court succinctly explained that the Bruins’ banquet contracts constituted a lease of the rooms provided for meals and that the contracts also meant that the Bruins operated the facilities under Treasury Regulation § 1.132-7(a)(3).  In doing so, the Tax Court summarily dismissed the IRS’s argument that the payment of sales taxes meant that the contracts were not contracts for the operation of an eating facility but instead the purchase of meals served in a private setting.

Having determined that the first two criteria were satisfied, the Tax Court turned to the question of whether the hotel banquet rooms constituted the “business premises of the employer.”  The court looked to a series of cases indicating that the question was one of function rather than space.  Relying on those cases, the court determined that the hotels were the business premises of the employer because the team’s employees conducted substantial business activities there.   The court seemed to put significant weight on the fact that the team was required to participate in away games, necessitating it travel and operation of its business away from Boston.  The Tax Court was unpersuaded by the IRS’s quantitative argument that the team spent more time working at its facility in Boston than at any individual hotel and its qualitative argument that the playing of the away game was more important than the preparation for the game that took place at the hotel.

Having determined that the hotel banquet rooms were an employer-operated eating facility, the Tax Court next addressed whether it qualified as a de minimis fringe benefit because more than half of the employees who were furnished meals in the banquet rooms were able to exclude the value of such meals from income under section 119 of the Code.  The court determined that this requirement was satisfied because the meals were provided to the team and staff for substantial noncompensatory business reasons.  The business reasons included: ensuring the employees’ nutritional needs were met so that they could perform at peak levels; ensuring that consistent meals were provided to avoid gastric issues during the game; and the limited time to prepare for a game in each city given the “hectic” hockey season schedule.  Relying on the Ninth Circuit’s decision in Boyd Gaming v. Commissioner from the late 1990s, the court declined, once again, to second guess the team’s business judgment by substituting the government’s own determination.

Although the decision focuses on the specific facts and the exigencies of a traveling hockey team, the decision is of interest for other taxpayers as well.  This is especially true given the IRS’s recent increased interest in both meal deductions and the imposition of payroll tax liabilities with respect to free or discounted meals provided to employees, particularly in company cafeteria settings.  The decision expands the scope of the section 119 exclusion to meals further than the IRS’s current limited view that it applies only to remote work sites, such as oil rigs, schooners,  and camps in Alaska.   To date, the most expansive application of the exclusion in the company cafeteria setting occurred in Boyd Gaming, where a casino successfully established that its policy requiring employees to eat lunch on-site was based on security concerns and the attendant screening procedures made it necessary to provide employees with meals during their shifts.

Jacobs seems to take the analysis one step further, because many of the business reasons for providing meals to Bruins employees could be echoed by other taxpayers.  No doubt, all employers are concerned with the performance of their employees.  To that end, it could be argued that ensuring that they eat well-balanced nutritionally appropriate meals can increase performance even if the employer is more concerned with brains rather than brawn.  Indeed, given the large health insurance costs borne by many employers, employers have a legitimate interest in providing healthy meals that may reduce the incidence of obesity, diabetes, heart disease, and other chronic ailments that raise their costs.  Moreover, many employees have hectic schedules during the work day with frequent appointments, meetings, and other activities that make it necessary to maximize the time available for work during the day.   Given the Tax Court’s implicit admonition of the IRS’s attempt to substitute its own judgment regarding the employer’s business reasoning in Jacobs and the court’s refusal to substitutes its own judgment as well, the IRS likely has a more difficult road ahead if it attempts to challenge the purported business reasons that an employer provides for furnishing meals to its employees.  It remains to be seen how the IRS will react to the decision and whether it will appeal the case, which seems likely.  For now, however, the case is a positive development for employers who have made a business decision to provide meals on a free or discounted basis to their employees to increase productivity and improve their health.