Coping with the lobbying deduction disallowance.

Lobbying expenses no longer are deductible for most entities.

Businesses, trade associations and others that lobby the government at the federal or state level are wrestling with implementation issues arising from a provision in the Omnibus Budget Reconciliation Act of 1993 denying deductions for lobbying expenses.

Revised Internal Revenue Code section 162(e) provides that expenses paid or incurred after December 31, 1993, to influence legislation and certain regulatory matters are not deductible. For businesses, compliance with the new law effectively requires establishing a system to capture information that will allow them to determine direct and indirect lobbying costs.

Under a proposed revenue procedure, the Internal Revenue Service would have section 162(e) apply also to trade associations and social welfare organizations, as well as to agricultural and horticultural organizations. Section 162(e) would not apply to other exempt organizations, such as country clubs or labor unions. Affected tax-exempt organizations face the same compliance issues as businesses, as well as the additional question of whether to pay taxes on lobbying expenses or pass the deduction disallowance on to members, if possible.

The IRS provided some guidance on the lobbying deduction disallowance, but fundamental questions remain, including a definition of lobbying itself. Two sets of regulations already have been proposed. One covers the deductibility of dues paid in 1993 to trade associations and other tax-exempt organizations that lobby; the other focuses primarily on safe-harbor methods for allocating expenses to lobbying activities. Additional guidance to define more clearly the types of lobbying activities for which deductions will be disallowed is expected later in 1994.

LOBBYING ACTIVITIES ARE ...

Complying with the new law requires lobbying activities to be identified. Section 162(e) says lobbying includes any attempt to influence legislation through communication with a member or employee of a federal or state legislative body or with a federal or state government official or employee who may participate in the formulation of legislation. Legislation includes acts, bills, resolutions or similar matters as well as proposals not yet in legislative form.

To be considered lobbying, a contact must refer to legislation or a legislative proposal and reflect a view on that legislation. Typical examples are meetings, telephone discussions and correspondence as well as planning, research and other preparation or coordination related to lobbying activities. It's not clear if a communication that does not reflect a view will constitute lobbying. Meetings for which lobbying is not a "substantial purpose," however, are not considered lobbying according to proposed IRS regulations. One example might be a widely attended meeting at which a legislator gives a speech.

For purposes of section 162(e), lobbying includes attempts to influence any nonlegislative action of high-ranking federal government officials known as "covered executive branch officials." This group is limited to the president, the vice-president, cabinet-level appointees, certain White House personnel and their immediate deputies. Costs incurred in activities aimed at influencing state officials' or lower level federal bureaucrats' nonlegislative actions remain deductible.

Special rules are anticipated for "monitoring" activities. Monitoring legislation, when there is no current attempt to influence its formulation or enactment, is not treated as lobbying under the new law. However, when monitoring later is followed by an attempt to influence the formulation or enactment of the same or similar legislation, earlier monitoring costs may be recharacterized as nondeductible lobbying expenses. Future IRS guidance is expected to prescribe the reach of this "lookback" rule. Regulations also will need to define what types of activities constitute monitoring.

Efforts to influence legislation at the county, city or other local level are not affected by the disallowance rule and remain deductible as under prior law. However, grass-roots lobbying on legislation, referendums or initiatives remains nondeductible, whether at the federal, state or local level.

LOBBYING EXPENSES ARE ...

Having determined which of their activities constitute lobbying, taxpayers then will need to determine which expenditures are associated with those activities, including certain in-house expenses as well as third-party lobbying costs.

In-house lobbying expenses include direct costs, such as a portion of salaries and travel and entertainment (T&E) expenses to the extent they are attributable to lobbying. In-house expenses also include certain indirect costs--expenditures that might not appear at first to be tied to lobbying. These include a percentage of general overhead, costs associated with the human resources department or general counsel staff and other expenditures to the extent they are attributable to lobbying. The IRS proposed several safe harbors, discussed below, to help taxpayers determine such expenses. Also, section 162(e) says the deduction disallowance does not apply to lobbying expenses if they do not exceed $2,000 for the tax year excluding overhead).

Lobbying expenses include payments to outside groups or third parties for lobbying activities as well as the nondeductible portion of any dues related to lobbying. Taxpayers generally are permitted to rely on these outside lobbyists to provide information that allocates fees and reimbursed expenses between lobbying and other activities.

COMPUTING TOTAL LOBBYING EXPENSES

Lobbying expenses equal the total of in-house expenses plus third-party lobbying expenses. Invoices, billings and other existing documents will make calculating a taxpayer's third-party lobbying expenses relatively simple. On the other hand, calculating in-house expenses attributable to lobbying appears, on its face, to require taxpayers to wade through numerous office expense records to allocate some portion of each to lobbying.

Fortunately, the IRS proposed optional safe-harbor methods for calculating in-house lobbying expenses. Two would allow taxpayers to avoid tracking certain expenses such as overhead and T&E. Instead, they generally require taxpayers to capture only labor costs. Most taxpayers appear to be giving serious consideration to using one of these safe-harbor methods:

* Ratio method. In-house lobbying expenses generally are deemed to be equal to the total cost of operations multiplied by a fraction, the numerator of which is lobbying labor hours and the denominator of which is total taxpayer labor hours. Hours spent by secretarial, maintenance and similar personnel can be excluded from both the numerator and the denominator.

* Gross-up method. Taxpayers first divide the hours spent lobbying by the hours worked in a year for each employee. The result is multiplied by basic labor costs, such as wages or salaries; pension or other qualified benefit costs are excluded. This amount then is multiplied by 175% to determine total in-house lobbying expenses for each employee. The sum of all these amounts for all employees considered to be engaged in lobbying activities is the amount disallowed.

Note: Neither the ratio nor the gross-up method can be used by partnerships or sole proprietorships in which the lobbying activities are performed by owners who do not receive salaries or other guaranteed payments for services.

In calculating total employee hours spent lobbying under both methods, employers can disregard efforts by personnel who spend less than 5% of their time lobbying. This rule, however, does not apply to "direct contact" with legislators or covered executive branch officials, such as meetings, telephone conversations, letters or similar means of communication. Thus, time spent on direct contact lobbying, as well as preparation and travel time spent in connection with such lobbying, are allocated to lobbying activities even if the individual spends less than 5% of his or her time lobbying.

Neither the law nor any IRS guidance provides, or is expected to provide, specific recordkeeping rules for lobbying. Therefore, taxpayers have several recordkeeping options for capturing the time their employees spend on lobbying and related expenses. The most effective option might be to require employees involved in lobbying to keep daily time sheets. Many taxpayers are tracking lobbying labor costs by modifying existing T&E reports or creating new reports to be submitted by employees on a periodic basis that include the number of hours or percentage of time devoted to lobbying and, where appropriate, out-of-pocket lobbying expenses.

A third safe harbor requires taxpayers to allocate costs to lobbying by applying the principles of IRC section 263A's uniform capitalization regulations. This approach, however, could entail an overhaul of a taxpayer's entire cost accounting system.

PAY TAX OR PASS IT ON?

Once total lobbying expenses for a year are determined, the question remains for trade associations and other affected tax-exempt organizations whether to elect to pay taxes on such amounts or pass the disallowance to members by disclosing the portion of their dues allocable to nondeductible legislative activities. (For information on how the American Institute of CPAS will handle this, see Inside AICPA, page 91.)

If an association chooses to pay taxes on lobbying expenses, the amount spent on lobbying activities during the year is taxed at the top corporate income tax rate of 35%. Amounts an organization spends on lobbying are deemed to come solely from dues. As a result, the amount taxed cannot exceed total dues for the year. If total lobbying expenses exceed dues, the excess is treated as paid or incurred by the organization in the following year.

If an association elects to pass the deduction disallowance on to its members, it must include an estimate of the portion of dues it expects to use for nondeductible lobbying expenses in its dues notices or inform members when they pay their dues. The notice must be conspicuous and easily recognized.

Note: In December 1993 the IRS issued temporary regulations providing that dues paid on or before December 31, 1993, are not deductible by members if the organization notified them such dues were allocable to lobbying expenditures to be paid or incurred by it after 1993. (This regulation restates the position taken in IRS notice 93-55.) On the other hand, if dues paid in 1993 are allocable to lobbying expenses paid or incurred by the exempt organization before 1994, deductibility is determined under pre-1993 law.

If an association's total nondeductible lobbying expenses are greater than initially estimated, a 35% tax on the excess expenditures will be imposed, unless the organization agrees to include the excess in its estimate of nondeductible lobbying expenses for the following year. If the association chooses to pay the tax, it may be subject to penalties for underpayment of estimated taxes.

There is no adverse tax impact on associations that overestimate the portion of dues that will be used for lobbying. However, members lose a deduction for the entire amount. The legislative history contemplates the Treasury Department and the IRS will develop a mechanism to compensate association members.

MORE TO COME

Several key issues under section 162(e) remain to be addressed by the IRS, including questions of what is considered an attempt to influence legislation. Meanwhile, some groups have filed suits to overturn the lobbying deduction disallowance on constitutional grounds, but observers doubt such challenges will be upheld. Some in Congress, however, may explore limiting the scope of section 162(e) by, for example, excluding lobbying activities at the state level.

EXECUTIVE SUMMARY

* LOBBYING EXPENSES OF businesses, trade associations and others that lobby the government at the federal or state level generally are no longer deductible under Internal Revenue Code section 162(e).

* TAX-EXEMPT ORGANIZATIONS face the question of whether to pay taxes on their nondeductible lobbying expenses or pass the deduction disallowance on to their members.

* THE INTERNAL REVENUE Service provided guidance on some unanswered questions in two sets of regulations. Certain safe harbors also were established to make complying with section 162(e) easier, but unresolved questions remain.

* LOBBYING ESSENTIALLY IS ANY attempt to influence legislation through communication with a member or employee of a federal or state legislative body or a federal or state official or employee who may participate in formulating legislation. High-ranking federal government officials, including the president, vice-president, cabinet-level appointees and certain White House personnel, also are included.

* EMPLOYEES INVOLVED IN lobbying must keep careful track of the time they spend in this pursuit. Entities must record related expenses and overhead. New recordkeeping systems may be needed to do so.

DAVID M. REPASS, JD, is a senior manager with Price Waterhouse national tax services in Washington, D.C. JEFFREY R. LEVEY is a senior manager in the Price Waterhouse national tax services' D.C. office. JAMES F. CARLISLE, JR., is a manager with Price Waterhouse national tax services in Washington.