Compensation and Residual Gross Income
Chapter 5: § 61(a)(1) Compensation
B. Section 132
In the late 1970s, Treasury decided to issue additional regulations under § 61(a)(1) to clarify what other kinds of in-kind compensation (other than meals and lodgings provided for the convenience of the employer under § 119) could be excluded from Gross Income, notwithstanding
§ 61(a)(1), because complaints had arisen that different employers were given varying IRS advice regarding the same sorts of items. Congress responded by imposing a moratorium in 1978 on new Treasury regulations pertaining to this issue, providing Congress some time to enact new statutory provisions. Finally, in 1984, Congress enacted § 132 and added the language regarding “fringe benefits” to § 61(a)(1), thus making it clear that no common law exclusions exist with respect to
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compensation. Absent explicit statutory authority to exclude, all compensation—whether paid in cash or in kind—must be included in Gross Income under § 61(a)(1).
Excerpt from General Explanation of the Revenue Provisions of the Deficit Reduction Act of 198414
Reasons for Change
In providing statutory rules for exclusion of certain fringe benefits for income and payroll tax purposes, the Congress struck a balance between two competing objectives. First, the Congress was aware that in many industries, employees may receive, either free or at a discount, goods and services which the employer sells to the general public. In many cases, these practices are long established, and generally have been treated by employers, employees, and the Internal Revenue Service as not giving rise to taxable income.
[W]here an employer has only one line of business, the fact that the selection of goods and services offered in that line of business may be limited in scope makes it appropriate to provide a limited exclusion, when such discounts are generally made available to employees …. By contrast, allowing tax-free discounts for all lines of business of a conglomerated organization, where the employee might have unlimited choices among many products and services which individuals normally consume or use on a regular basis, would be indistinguishable in economic effect from allowing tax-free compensation in the form of cash or gift certificates. Also, the noncompensatory element involved in providing discounts on the particular products or services that the employee sells to the public may be marginal or absent where an employer offers discounts across all lines of business.
…
The second objective of the new statutory rules is to set forth clear boundaries for the provision of tax-free benefits…. Congress was concerned that without any well-defined limits on the ability of employers to compensate their employees tax-free by providing noncash benefits having economic value to the employee, new practices will emerge that could shrink the income tax base significantly. This erosion of the income tax base results because the preferential tax treatment of fringe benefits serves as a strong motivation to employers to substitute more and more types of benefits for cash compensation. A similar shrinkage of the base of the social security payroll tax could also pose a threat to the viability of the social security system above and beyond the adverse projections which the Congress addressed in the Social Security Amendments of 1983. In addition, continuation of the dramatic growth in noncash forms of compensation—at a rate exceeding the growth in cash compensation—could further shift a disproportionate tax burden to those individuals whose compensation is in the form of cash.
Finally, an unrestrained expansion of noncash compensation would increase inequities among employees in different types of businesses, because not all employers can or will provide comparable compensation packages…. [A]n unlimited exclusion for noncash benefits discriminates among employers. For example, if tax-free discounts were allowed across all lines of business of an employer, a large employer with many types of businesses (e.g., department store, hotel, airline, etc.) would be given a favorable edge by the tax system in competing for
14STAFF OF THE JOINT COMM. ON TAX’N,GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984,JCS-41-84, 840-42 (Dec. 31, 1984).
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employees as compared with a small firm having one line of business (e.g., a specialty clothing store)….
Accordingly, the Congress determined that specific rules of exclusion should be set forth in the Code, with limitations on the availability, applicability, and scope of these statutory exclusions.
These general limitations include a nondiscrimination rule, the line of business limitation, and the limitation on exclusions to benefits provided to the employee and the employee’s spouse and dependent children….
The nondiscrimination rule is an important common thread among the types of fringe benefits which are excluded under the Act from income and employment taxes. Under the Act, most fringe benefits may be made available tax-free to officers, owners, or highly compensated employees only if the benefits are also provided on substantially equal terms to other employees. The Congress believed that it would be fundamentally unfair to provide tax-free treatment for economic benefits that are furnished only to highly paid executives. Further, where benefits are limited to the highly paid, it is more likely that the benefit is being provided so that those who control the business can receive compensation in a nontaxable form; in that situation, the reasons stated above for allowing tax-free treatment would not be applicable….
These amendments made clear that any fringe benefit that does not qualify for exclusion under a specific Code provision is includable in the recipient’s Gross Income, and in wages for withholding and other employment tax purposes, at the excess of the fair market value of the benefit over any amount paid by the recipient for the benefit.
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Note the concern repeatedly stated in the legislative history excerpt about possible damage to the tax base if consumption provided in kind (as compensation) were broadly excludable. A broad exclusion would encourage the substitution of in-kind compensation (excludable) for cash compensation (includable). Such a substitution would be inefficient, causing a tax-motivated change in behavior, as it is easier for most employers to pay compensation in cash rather than in kind. Moreover, always remember that tax-base-narrowing provisions are never costless; the resulting reduction in tax base would require tax rates to be higher than they would otherwise need to be to raise $X, raising additional efficiency concerns.
The original version of § 132 enacted in 1984 contained only the provisions now listed in § 132(a)(1) through (4), pertaining to the no additional cost service, the qualified employee discount, the working condition fringe, and the de minimis fringe, as well as the exclusion for qualified tuition reductions for employees of educational institutions, added to the Code in § 117(d) (considered in Chapter 17). Subsequent acts have since expanded § 132 to address the qualified transportation fringe, the qualified moving expense reimbursement, the qualified retirement planning service, and the qualified military base realignment and closure fringe.
Compensation excludable for Federal income tax purposes under § 132 is also not taxed as
“wages” under the payroll taxes (Social Security and Medicare).
The employer is typically the party that seeks to determine whether an item is includable or excludable because, if the item is includable, the employer must (1) withhold and send to Treasury the estimated income tax, as well as payroll taxes, owed by the employee from remaining cash wages, (2) pay its employer share of the payroll taxes on these amounts, and (3) include those amounts in the year-end Form W-2 that is sent to the employee. The IRS may choose to conserve
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resources by pursuing fringe benefit issues primarily with employers.
For example, in American Airlines, Inc. v. United States,15 American Airlines gave to every employee a $50 American Express “Be My Guest” voucher that could be used like cash at any establishment that accepted American Express credit cards as a gesture of appreciation for the employees’ extra work effort during a labor dispute at a competing airline that substantially increased American’s passenger load. American Airlines decided on the voucher in lieu of a firm-wide banquet. The face amount of the vouchers totaled $4,250,000, and more than 97% were redeemed. American did not include the vouchers in the employees’ Gross Incomes for income and payroll tax purposes and did not pay the employer share of payroll taxes on the amount, arguing that the vouchers could be excluded as a de minimis fringe within the meaning of § 132(e)(1). While a firm-wide banquet would have been excludable as a de minimis fringe under Treas. Reg. § 1.132-6(e)(1), which provides exclusion authority for “occasional cocktail parties, group meals, or picnics for employees and their guests” (emphasis added), the vouchers were held not to be excludable because they constituted “cash equivalent fringe benefits” within the meaning of Treas. Reg. § 1.132-6(c). Notice that the IRS pursued this issue with the employer, not the numerous employees.
Problems
These problems provide an opportunity for close parsing of the statute and regulations. While I sometimes cite helpful Treasury regulations, always start with the statutory language at issue in each problem before turning to the cited regulations. In particular, before embarking on the problems, carefully read § 132(a), (b), (c), (d), (e), (f), (j)(1), and (h)(2)(A), (h)(3).
Section 132(h)(3) was added in 1985. Why would Congress specify that use by parents qualify as use by employees only in the case of airline transportation? The Chairman of the House Ways and Means Committee, where all tax legislation originates, was Dan Rostenkowski, who sponsored the 1985 legislation. I understand that his two daughters worked for an airline that provided free air travel on a space-available basis for parents of employees (in addition to spouses and dependents). As my nieces and nephews commonly observe, “just sayin.”
1. Holly works as a flight attendant on Hilarity Airlines, owned by Conglomerate, Inc., which also owns Hooyacht Hotels. Conglomerate allows all of its employees, as well as their spouses and children, to fly for free (Hilarity Airlines) or stay for free (Hooyacht Hotels) on their vacations on a space-available basis. Holly and her husband Hal use this perk to fly at no cost to Hawaii (FMV
$600 each for a total FMV of $1,200), where they stay for free in a room at the Hooyacht Hotel in Honolulu for 5 nights (FMV $2,000 for all 5 nights). On the flight to Hawaii, they ate free meals and drank beverages. At the Hooyacht Hotel, the maid serviced their room each day, cleaning their room while there were on the beach. Which fringe benefit exclusion might apply to the facts? What are the separate and independent requirements that must be satisfied for the exclusion provision to apply? After isolating possible statutory issues, see Treas. Reg. §§ 1.132-2(a)(5)(ii) and -4(a)(1)(i) for help in resolving them.
2. Same as 1. except that Holly is an Executive Vice President of Hilarity Airlines rather than a flight attendant, and only executives are allowed to fly for free on Hilarity Airlines or stay for
15 204 F.3d 1103 (Fed. Cir. 2000).
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free in Hooyacht Hotels on a space-available basis. All employees other than executives get a 50%
discount for flying or staying in the hotel on a space-available basis. Thus, on the same flight that Holly and her husband took, non-executives would have had to pay $300 each for the flight seats (worth $600 each). See Treas. Reg. § 1.132-8(a)(2).
3. Same as 1. (where Holly was a flight attendant), except that, in addition to being able to fly for free on Hilarity Airlines on a space-available basis, Holly is provided annually one voucher that allows her to make advanced reservations for confirmed seats for herself, her spouse, and her children. She uses this voucher to purchase two seats (for herself and her husband Hal) to fly to Paris (FMV $1,500 each for a total FMV of $3,000) for free. See Treas. Reg. § 1.1322(a)(2); -3(e).
4. Jack works as a salesperson at Jock Shoes, where he sells the latest designer athletic shoes.
All employees are permitted to buy shoes for personal use (not for friends) at a 40% discount. Jack purchases for $60 shoes that are sold to customers for $100. During the year, Jock Shoes has $1 million in total sales and $700,000 in cost of goods sold.
5. Sam works for Gold Unlimited, which buys and sells gold. All employees are permitted to buy gold at a 10% discount from the price at which gold is selling on that day. Sam purchases a quantity of gold for $900 on a day that gold is selling for $1,000 for the quantity that he purchased.
During the year, Gold Unlimited has $1 billion in total sales and $900 million in cost of goods sold. In addition to § 132(c)(4), read Treas. Reg. § 1.132-3(a)(2)(ii).
6. Sally is in-house corporate counsel (instead of a flight attendant) for Conglomerate, Inc., the owner of Hilarity Airlines and Hooyacht Hotels, described above. In addition to the perks noted above, Conglomerate agrees to pay 100% of the cost of professional association dues for all employees. Conglomerate pays Sally’s $275 American Bar Association dues for the year. In addition, Sally and her husband take advantage of the space-available policy noted above for flights and rooms to fly at no cost to Hawaii (FMV $600 each for a total FMV of $1,200), where they stay for free in a room at the Hooyacht Hotel in Honolulu for 5 nights (FMV $2,000 for all 5 nights). Sally does corporate work for both the Hilarity and Hooyacht lines of business. See Treas.
Reg. § 1.132-4(a)(1)(iii), (iv).
7. Conglomerate, Inc., supports the local theater complex that hosts touring Broadway shows.
Conglomerate provides to Jacob, an executive, one set of free theater tickets (FMV $250) to attend a touring company performance of a hot Broadway show for himself and his spouse. Only executives are provided such tickets. What if, instead, Conglomerate provides Jacob with $250 in cash to use in purchasing the tickets, rather than provides the tickets in kind? See Treas. Reg. § 1.132-6(e)(1) and -6(c).
8. Conglomerate, Inc., reimburses Jacob for the cost of his dinner approximately four nights each month when he works late at the office. Conglomerate does not reimburse dinner costs for non-executives who must work late. See Treas. Reg. § 1.132-6(d)(2).
9. Conglomerate, Inc., has a cafeteria in its headquarters building that is open to all employees.
The cafeteria charges low prices (substantially less than the FMV of the meals) in order to just
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break even in running the cafeteria. Must the employees include the difference between the FMV of the meals and the price paid for them? Assume that § 119 is not satisfied on the facts. See § 132(e)(2). What if the facility is an Executive Dining Room open only to Executives?
10. Conglomerate, Inc., reimburses Jacob for his parking costs in a garage close to the office building at a cost of $150 each month. Only executives’ parking costs are reimbursed.
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Suppose that you rack up frequent flier miles on business trips reimbursed by your employer and that you subsequently use those frequent flier miles to take a personal trip. That personal trip was, in substance, paid for by your employer because the miles used to take the trip were compiled on travel paid for by your employer. Nevertheless, the IRS has announced that it will not seek to tax the use of such frequent flier miles unless the employee is able to convert them to cash,16 as occurred in Charley v. Commissioner.17