Deducting Fringe Benefits
Many companies provide their employees with fringe benefits. Congress has imposed income inclusion requirements on employees and deduction limits on employers. Recently, in a case of first impression, the Eighth Circuit Court of Appeals decided whether the income and deduction must be equal.
Sutherland Lumber–Southwest Inc. allowed several of its officers to use the corporate jet for nonbusiness purposes such as vacations and charitable activities. The company treated this use as a fringe benefit and included an amount in the employees’ income based on the formula in Treasury regulations section 1.61-21(g)(5). The company deducted the full cost of maintaining the jet. The deduction exceeded the income the employees reported. The IRS reduced the deduction so it was equal to this amount. The Tax Court sided with the taxpayer and allowed the full deduction. The IRS appealed.
Result. For the taxpayer. IRC section 274 denies a deduction for expenses related to entertainment facilities except as provided in that section. Section 274(e)(2) says expenses for goods, services and entertainment facilities are exempt from the prohibition in section 274(a) “to the extent that” the employee treats them as wages. That language, the government argued, requires that the deduction be limited by the income reported. The Eighth Circuit agreed with the Tax Court that when Congress intends such language to impose a limit, it specifically states the limit. Since section 274(e)(2) does not include a limit, the correct interpretation is that this section removes the expenses from section 274 entirely and instead requires the taxpayer to use the general rule of section 162 to determine deductibility.
The appeals court also adopted the Tax Court’s rejection of the IRS position that section 274 was intended to equalize the income and the expense. The congressional record did not support the IRS argument. In addition, since the service did not object to cases where the income reporting formula resulted in the reported income exceeding the expense deduction, there was no equality requirement.
Sutherland left two items unresolved. The taxpayer argued that an aircraft was not an entertainment facility. Since the taxpayer had won on other grounds, the appeals court refused to decide this issue. Second, since section 162 applied, the expenses were limited to amounts that were ordinary and necessary. The court did not consider what a “reasonable expenditure” would have been here.
This case should end the dispute over income and expense parity. Entertainment expenditures included in income are deductible in full provided they meet the requirements of section 162.
Sutherland Lumber–Southwest Inc. v. Commissioner, 88 AFTR2d 2001-5001, CA8.
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.