Now that new tax rules are in place, employers and their advisers are coping with the difficulties faced in implementing the changes, adjusting to a new normal. New tax laws are always a product of give-and-take, with many constituencies fighting to retain favorable rules and congressional staff putting the pieces together so there are enough votes to pass the legislation. The changes brought about by P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), are no exception.
The goal of lowering tax rates, primarily for businesses, needed to be tempered by eliminating certain business deductions or individual income tax exclusions so that federal revenues didn't decline too much. The elimination of employer deductions or individual income tax exclusions causes taxpayers to consider behavior adjustments to account for the increased cost of the formerly deductible or excludable expense. Never has this adjustment had to occur so quickly, with the TCJA legislation enacted on Dec. 22, 2017, and many effective dates occurring only 10 days later, on Jan. 1, 2018.
Congress is always concerned that certain business deductions or individual income tax exclusions may not be fair to all taxpayers, as some individuals and businesses benefit more than others from tax incentives. To eliminate this unfairness, Congress can either (1) eliminate the business deduction for incurring the expense, or (2) in the case of employee benefits, tax the individuals receiving the benefit. While both approaches accomplish the same tax policy result of not providing an income tax incentive for certain behaviors, the effect on Social Security taxes and the optics of the change are quite different. In one case, the cost to business for the expense is increased, and, in the other, the cost to individuals for receiving the benefit is increased. Of course, the true economic cost of these changes is borne by business owners and employees, with the relative changes for each group being dictated by their own adjustments to accommodate the increased tax costs.
This article addresses two common business expenses whose tax rules changed beginning Jan. 1, 2018: entertainment expenses and transportation fringe benefits. While the TCJA legislative changes were not detailed, the effects are significant. Without detailed legislative changes, the hard work falls to tax administrators and professionals as they help taxpayers cope with the required changes. In these two areas, administrative guidance will be particularly important. Guidance, by necessity, will follow the statute, taking into account the legislative history. However, where interpretations of the statute can differ or issues are not addressed by the statute or committee reports, the guidance may reflect the interpretation of the current IRS and Treasury leadership.
As tax advisers, we are called upon to help clients implement the new law with limited and incomplete guidance. The best we can do is make our own decisions on what is reasonable and what rules we think may be promulgated later, understanding that tax administrators may be liberal in transition relief for unexpected or significant changes and tax enforcers may be willing to accept a reasonable interpretation. This article offers practical approaches to dealing with implementing these tax rules, in a world of less than complete guidance.
Entertainment expenses — no longer deductible
Under TCJA, entertainment expenses incurred on or after Jan. 1, 2018, are nondeductible. Prior to the most recent tax law changes, entertainment expenses were 50% deductible to the extent that they were directly related to, or, in the case of an item directly preceding or following a substantial and bona fide business discussion, associated with, the active conduct of a trade or business. Detailed regulations further defined when this could occur.
Over the years, businesses interpreted many activities as falling within these exceptions, liberally interpreting the regulatory rules to claim more deductions for entertainment costs. IRS agents tended to ignore these costs, except where expenses were clearly entertainment (e.g., trips to the Super Bowl). Over the years Congress enacted additional limitations on expenses, focusing on meal expenses, spousal travel, and conventions outside North America. Beginning in 2018, U.S. taxpayers will no longer be funding a portion of these entertainment costs through tax incentives as the new law makes all entertainment expenses nondeductible. (Interestingly, tax-exempt organizations are not affected by these rule changes except to the extent associated with unrelated business income, likely because tax-exempt status appropriately limits all those expenses with the rule requiring expenses to promote the organization's exempt purpose.)
One of the most controversial areas that guidance will need to address is whether business meals with current and prospective clients are considered entertainment expenses and thus nondeductible. It may seem obvious that when a business owner shares a restaurant meal that is not lavish or extravagant with a current client or customer during which several topics are discussed, including the health of each other and their families, recent political developments, and business news affecting the client's industry, as well as the current and expected future projects for the client/customer, that the cost should be 50% deductible, just as business meals with other employees of the same firm are 50% deductible. (In 1986, Congress limited the deduction for meal expenses to 80% of the cost, further limiting the deduction to 50% in 1993, as a way of recognizing that the personal expense of eating should not receive tax benefits.)
However, what if the person joining the taxpayer is not a current client, but rather another professional or a prospective client? Isn't it just as important to maintain contact with prospective clients and other professionals as with current clients? If so, should the business cost of doing so be any different?
Some commentators suggest that even the business meal with a current client or a meal with a prospect or other business relationship may be nondeductible as an entertainment expense. Their argument is based on the development of the tax law since entertainment expense deductions were prohibited in 1962, with an exception for business meals in circumstances conducive to business deductions (repealed in 1986), current regulations, and case law. IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, which has not been modified since enactment of the legislation, makes the distinction between entertainment and nonentertainment meals meaningful and provides insight into how the IRS views meals:
A meal as a form of entertainment. Entertainment includes the cost of a meal you provide to a customer or client, whether the meal is a part of other entertainment or by itself. A meal expense includes the cost of food, beverages, taxes, and tips for the meal. To deduct an entertainment-related meal, you or your employee must be present when the food or beverages are provided.
Taxpayers will prefer to look to the TCJA conference committee report, which describes both the House bill and Senate amendment by stating, "Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel)" (H.R. Conf. Rep't No. 115-466, 115th Cong., 1st Sess. 460 (Dec. 15, 2017)). A parenthetical phrase highlighting an example of food and beverage expense associated with operating a trade or business, suggests that this is not the only example. It appears then that Congress's intent is for business meals that are not incurred while traveling should be treated similarly.
In fact, former Ways and Means Committee Chairman Dave Camp's proposal, the Tax Reform Act of 2014, H.R. 1 (113th Cong.), which included this change, stated the rule more broadly. "The 50-percent limitation under current law would apply only to expenses for food and beverages and to qualifying business meals under the provision, with no deduction allowed for other entertainment expenses" (Ways and Means Committee Majority Staff, Tax Reform Act of 2014, Discussion Draft, Section-by-Section Summary, p. 64 (2014)). Additionally, congressional committee staffers have informally indicated that it was not Congress's intent to limit deductions for business meals that are not lavish or extravagant beyond the 50% limit already in place.
If there was not uncertainty on this point, however, the AICPA and others would not be asking IRS for additional guidance. While we wait for guidance, how should we be advising clients? We should caution clients that amounts may not be deductible, and we will not know if they are until IRS guidance is issued. Before that time, we may get some helpful language in the Joint Committee on Taxation's Bluebook, a description of the legislative changes. Until that time, for purposes of making estimated tax payments, taxpayers may want to conservatively assume that amounts are not deductible.
Next year, as tax returns are prepared, there should be a review of all these expenses taking into account all guidance issued by then. Certainly, we believe that it is fair and reasonable that business meals with a business purpose and intent are deductible. Tax administrators, realizing the importance of these rules for many taxpayers, will no doubt make every effort to issue guidance as soon as possible, with generous transition rules to the extent that the changes are unexpected.
Transportation fringe benefits
In the early 1990s, Congress wanted to provide incentives to use mass transit and limit the exclusion for employer-provided parking to a specified dollar amount, and enacted an exclusion for qualified transportation fringe benefits. While those benefits could be provided through a reimbursement arrangement (i.e., one in which the expense incurred by employees was reimbursed tax free by the employer, assuming substantiation requirements were met), amounts could not be provided in lieu of compensation. That rule changed for tax years beginning after 1997 when Congress provided that an employee could choose to reduce compensation to receive a nontaxable qualified transportation fringe benefit. The use of employer-provided parking exploded as a tax-free fringe benefit.
By its nature, this is a benefit enjoyed primarily by employees working in urban areas, where parking is expensive. Camp's proposal noted that elimination of a deduction for qualified transportation fringes aligns the treatment with amenities provided to employees that are primarily personal in nature and not directly related to a trade or business. Not wanting to eliminate an individual income tax exclusion, Congress decided to leave the exclusion in place and eliminate the employer's expense deductions associated with this benefit. To include tax-exempt and governmental organizations where elimination of a tax deduction is not meaningful, Congress made those amounts subject to unrelated business income tax.
Some have thought that the salary reduction provisions of qualified transportation fringes provide an opportunity to avoid the disallowed deduction rule, because it appears that the employee is funding the benefit. However, that is not correct. If an employee reduces future compensation on a pre-tax basis in exchange for the employer providing parking, the parking benefit is a provision of a qualified transportation fringe benefit, the costs of which would be disallowed. However, if the salary reduction is on an after-tax basis, the employee is not receiving a qualified transportation fringe and the disallowed deduction or, in the case of a tax-exempt organization, unrelated business income is avoided.
Qualified parking is a qualified transportation fringe benefit. As such, there is a disallowed cost that the employer must determine for qualified parking. To determine that cost, taxpayers should look to lease costs or ownership costs and, if amounts are not separately stated, make a good-faith allocation of these costs, taking into account the relative fair market values of the various items included in the lease or ownership costs. For example, a parking lot owned by a business may have snow removal, depreciation, maintenance, security, and similar expenses. There may be costs to administering a program that provides transit passes to employees. The employer will need to aggregate all of these costs and, if the costs relate to employee and nonemployee use, allocate the costs between employees' use and others' use. A conservative approach to accumulating and identifying nondeductible costs should be applied in 2018 tax planning.
Value of parking benefit
Because the employee exclusion amount is the fair market value (FMV) of the parking benefit provided, and the disallowed employer deduction is the cost of providing that parking benefit, questions arise regarding whether a value of $0 for qualified parking might eliminate the existence of the qualified transportation fringe benefit as the provision of the benefit by the employer is not a provision of anything of value.
Notice 94-3 provides helpful guidance by stating:
Generally, the value of parking provided by an employer to an employee is based on the cost (including taxes or other added fees) that an individual would incur in an arm's length transaction to obtain parking at the same site. If that cost is not ascertainable, then the value of parking is based on the cost that an individual would incur in an arm's-length transaction for a space in the same lot or a comparable lot in the same general location under the same or similar circumstances.
The notice continues by helpfully giving an example of an industrial plant in a rural area in which no commercial parking is available. In this example, while the employer provides parking free of charge, the FMV of the parking would be $0 because nonemployees would not normally pay for parking. The implication is that with a $0 market value, there is no qualified transportation fringe benefit. With no qualified transportation fringe benefit, the TCJA rule limiting employer deductions for qualified transportation fringes may not apply. (However, the inability to deduct commuting expenses may apply, if parking is considered to be part of commuting.)
A second example highlights an additional rule for parking available for customers (e.g., at a mall that provides free parking to customers and employees). Under that rule, only if an employer maintains reserved preferential spaces (i.e., parking spaces that are more favorably located than the spaces available to customers) for employees would the FMV of $0 rule not apply.
Notice 94-3 applies to the income exclusion rule for qualified transportation fringe benefits and may not extend to this new disallowed deduction rule. The TCJA deduction limitation focuses on employer costs incurred and not employee value received. Thus, even if the $0 FMV rule applies, the employer may have a cost disallowed, since the employer likely has expenses for lease or maintenance of a parking lot and other related expenses.
While this is a reasonable position, IRS guidance is needed to be confident that a value of $0 could result in no disallowed deduction. Until that time, taxpayers should be conservative and assume that if the employer incurs costs for providing qualified transportation fringes, possibly including parking with a $0 FMV under the rules of Notice 94-3, there is a disallowed cost that must be determined. Again, a conservative approach can only bring good news when tax returns are prepared and guidance is available.
Deborah Walker is national director of Cherry Bekaert LLP's Compensation and Benefits Solutions Group and a member of the AICPA Employee Benefits Tax Technical Resource Panel. Sarah McGregor is director of Tax Services at Cherry Bekaert and a member of the AICPA S Corporations Tax Technical Resource Panel. To comment on this article or to suggest ideas for other articles, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.