Employment Tax Bulletin (August 2010)
IRS Will Scrutinize Fringe Benefits
During Employment Tax Audits
J. O'Connor, a tax partner, and
Stoudt, a tax associate, both in the
Washington, D.C. office
of Pillsbury Winthrop Shaw Pittman
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The IRS intends to select large and small businesses as well as tax-exempt organizations and governmental entities for its Employment Tax National Research Project. While they will be comprehensive in scope, the audits will initially focus on issues the IRS had already identified as commonly giving rise to compliance problems, including employee/independent contractor classification, fringe benefits, employee reimbursements, and executive compensation. "Fringe benefits" include compensation other than salary and annual cash bonus, and the IRS will scrutinize both taxable and excludible fringe benefits.
Employment taxes are a major source of federal revenue and made up more than 44 percent of all IRS collections in fiscal year 2009. In part to address the tax gapthe disparity between taxes owed and taxes collectedthe IRS last fall announced that it would embark on an employment tax examination initiative this year. The first such initiative to be conducted in 25 years will mean IRS audits of 6,000 employers over the three year period 2010-2012. One of the initiative's most important objectives will be to determine problem areas in employment taxationthose areas with which companies have the most trouble with complianceso that future employment tax audits can be focused accordingly. One of the areas to be reviewed on audit is fringe benefits.
Fringe Benefits Issues
As with all employment tax issues, the IRS will be looking not only at how the employer accounts for the items in its own books and records and on its tax returns, but also how the employer reports them to the employee and how the employee and employer report them to the IRS. IRS agents will also want to see the employee handbook or other descriptions of the various elements of compensation or business expense reimbursement. And for non-cash benefits, the IRS will want documentation to support the valuation the employer assigned them.
Fringe benefits can be a valuable source of tax adjustments for the IRS. Most often, the employer can deduct them as compensation, and the employee must include them in income. From time to time, however, an employer might provide a benefit to an employee that, for one reason or another, it cannot deduct. And certain fringe benefits are deductible by the employer, but are not taxable to the employee ("excludible fringe benefits"). Both taxable and excludible fringe benefits are included in the current employment tax audit project.
The IRS's Fringe Benefits Audit Technique Guide directs the examiner to assume that the identified fringe benefit is taxable to the employee. Then the agent is to see if the benefit qualifies for a statutory exclusion. And finally the agent is to review the fringe benefit's valuation. To identify fringe benefits, the IRS will review accounts payable and cash disbursement registers, as well as such corporate documents as board of director minutes.
A Little Fringe Benefit History
In 1984, Congress added "fringe benefits" to the Internal Revenue Code's definition of gross income. At the same time, it added provisions under which certain fringe benefits would not be taxable to the employee. These excluded fringe benefits are:
- Working condition fringesproperty or services the employee would be entitled to deduct in determining taxable income as a trade or business expense had the employee paid for the item;
- De minimis fringesbenefits with a value so small that accounting for them is impractical (you'd be surprised how small this value has to beChristmas turkeys have been held not to qualify);
- No-additional-cost servicesservices provided to the customers in the ordinary course of business and provided to the employee at no substantial additional cost to the employer;
- Qualified employee discountsdiscounts provided to employees on the property or services the employer offers for sale to customers in the ordinary course;
- Qualified moving expensesamounts paid to an employee for expenses that would have been deductible moving expenses had the employee paid the expenses directly;
- Qualified transportation fringe benefitemployer-paid or subsidized commuting allowance;
- Qualified retirement planning servicesretirement planning services provided to an employee and his or her spouse by an employer that maintains a qualified employer plan; and
- Qualified military base realignment and closure fringe (added in 2003).
These excludible fringe benefits are each subject to specific conditions and are available only to employees or certain individuals treated as employees, i.e., not independent contractors.
Fringe Benefit Stakes Can Be High
In one case, $7.5 million in taxes (plus possible penalties and interest) was at stake and it took ten years of controversy before the decision was final. The IRS contended that the meal allowances IBM paid its employees when they worked outside their normal scheduled hours were taxable to them. IBM argued they were a de minimis fringe benefit. For the two years under examination, the IRS asserted an additional employment tax liability of more than $7.5 million. IBM paid the amount and sued for a refund. The United States Court of Federal Claims agreed with IBM, holding that the meal allowances were excludible because they were "occasional" and de minimis. While IBM ultimately prevailed, resolution of the case took a total of ten years, including a "lengthy and contentious period of discovery."
The 2010 wave of employment tax audits has commenced. You should begin to prepare by addressing fringe benefit issues through an internal audit to assure compliance.
This material is not intended to constitute a complete analysis of all
tax considerations. Internal Revenue Service regulations generally
provide that, for the purpose of avoiding United States federal tax
penalties, a taxpayer may rely only on formal written opinions meeting
specific regulatory requirements. This material does not meet those
requirements. Accordingly, this material was not intended or written to
be used, and a taxpayer cannot use it, for the purpose of avoiding
United States federal or other tax penalties or of promoting, marketing
or recommending to another party any tax-related matters.
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