IRS proposes using NAICS to determine lines of business for certain fringe benefit exclusions

Editor: Susan M. Grais, CPA, J.D., LL.M.

On Aug. 6, 2025, the IRS published proposed regulations (REG–132805–17, 90 Fed. Reg. 37824) that would use the North American Industry Classification System (NAICS) to determine an employer’s line or lines of business for purposes of determining the exclusions from gross income for (1) no–additional–cost services and (2) qualified employee discounts provided to employees. The NAICS would replace the Enterprise Standard Industrial Classification (ESIC) Manual.

Background

Sec. 132(a)(1) excludes from an individual’s gross income any fringe benefit that qualifies as a no–additional–cost service. A no–additional–cost service is any service provided by an employer to an employee for the employee’s use that is offered to customers in the ordinary course of the employer’s line of business and that does not incur any substantial additional cost to the employer (disregarding any amount paid for the service by the employee).

Sec. 132(a)(2) excludes from an individual’s gross income any fringe benefit that is a qualified employee discount, which generally applies to (1) qualified property sold to employees at a price at least equal to the employer’s cost and (2) qualified services sold to employees at a discount of no more than 20% of the price for which the services are offered by the employer to customers. Because the definitions of “wages” for federal employment tax purposes cross–reference Sec. 132, these income exclusions also produce wage exclusions (Secs. 3121(a)(20), 3306(b)(16), and 3401(a)(19)).

To qualify for the exclusions, the individual receiving the benefit must have performed substantial services in the employer’s line of business offering those services or property for sale to customers in the ordinary course of business. Under current Regs. Sec. 1.132–4(a)(2)(i), the line–of–business determination is made by referring to the ESIC Manual, which has not been updated since 1974. If an employer has more than a single line of business, the lines of business will be treated as a single line of business if certain aggregation rules apply.

Proposed regulations

The proposed regulations would replace the ESIC Manual with the NAICS to determine an employer’s line of business for purposes of excluding no–additional–cost services and qualified employee discounts from employees’ gross income. Specifically, the proposed regulations would base the employer’s line–of–business determination on the most recent NAICS four–digit industry group classification (Prop. Regs. Sec. 1.132–4(a)(2)).

Because the ESIC Manual has not been updated in over 50 years, many current industries are not listed because they did not exist (e.g., internet service providers, cellphone manufacturers, cellphone service providers, and smartphone application designers). The NAICS is updated every five years, most recently in 2022.

The proposed regulations would also update the aggregation rules to change the existing reference to a “department store” with a reference to a “general merchandise store, including a warehouse club or super center.” Consistent with the current rules, the separate lines of business would be treated as one line of business if:

• It is uncommon in the employer’s industry for any of the separate lines of business to be operated without the others;
• It is common for a substantial number of employees at an establishment to perform substantial services for more than one line of business of the employer, so that determining which employees perform substantial services for which line of business would be difficult; or
• The retail operations of an employer that are located on the same premises are in separate lines of business but would be considered to be within one line of business if the merchandise offered for sale was for sale at a general merchandise store, including a warehouse club or super center (Prop. Regs. Sec. 1.132-4(a)(3)).

The proposed applicability date for the proposed regulations is tax years beginning on or after the date final regulations are published in the Federal Register.

Implications

For decades, it has been unclear what to make of the current regulations’ reference to the outdated ESIC Manual. Some taxpayers have taken the position that it remains the relevant source unless and until the regulations are amended. The proposed regulations implicitly endorse that position. In many cases, this benefits taxpayers by treating as a single line of business what modern observers might intuitively consider separate lines of business.

Other taxpayers have taken the position that the NAICS, which is used for certain other federal tax purposes, should be used instead of the outdated ESIC Manual — a position that the proposed regulations explicitly endorse — but only prospectively and only if the proposed regulations are finalized.

These proposed regulations are not the first instance in recent memory when the NAICS has been used for Internal Revenue Code statutory interpretation. Sec. 512(a)(6), which requires unrelated business taxable income to be computed separately for each unrelated trade or business, also relies on the NAICS to make the necessary distinctions (Regs. Sec. 1.512(a)-6(b)).

Still other taxpayers may be unaware of the detailed requirements that must be met for free or reduced–price goods or services to be provided tax–free to employees. The publication of the proposed regulations draws attention to the existence of those requirements, which are not limited to the line–of–business limitation addressed in the proposed regulations. If the regulations are finalized, IRS examiners may likewise focus on these requirements more broadly.

The proposed regulations specifically invited taxpayers to comment on the use of the NAICS four–digit industry group code, whether any additional changes are necessary to the aggregation rules, and whether transition or other rules are necessary. Another issue on which commenters are likely to seek additional clarity is the applicability date’s reference to tax years (Prop. Regs. Sec. 1.132–4(a)(4)). Because these rules are predominantly relevant to employees with calendar–year tax years, it would seem that the relevant tax year should be the calendar year (rather than, for example, the employer’s fiscal year).

Editor

Susan M. Grais, CPA, J.D., LL.M., is a managing director (retired) at Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with Ernst & Young LLP.