Easy New Payroll Tax Savings from Employee-Paid Parking and Transit Benefits.

Almost eight years after the statute was enacted, the Internal Revenue Service has issued proposed regulations under section 132(f) of the Internal Revenue Code, which pertains to "qualified transportation fringes." This is welcome news, because for years employers have struggled with the uncertainties associated with administering qualified transportation fringe benefit plans, on a "salary reduction basis," without the benefit of adequate guidance. This article reviews the proposed regulations.(1)

Background of the Legislative Changes

The exclusion for "qualified transportation fringes" found in subsection (f) of section 132 was added to the Code by the Energy Policy Act of 1992(2)--an Act intended not only to raise revenue, but to encourage the conservation of energy and reduction of pollution by discouraging commuters from driving to work in single-person-occupied vehicles. This Act resulted in three changes to the way employers could offer certain commuting-related benefits to employees up to specific statutory monthly limitations. First, the value of transportation provided by an employer to an employee in a commuter highway vehicle (i.e., a van pool) became excludable up to $60 a month (adjusted for cost of living). Second, mass transit passes, previously excludable only as de minimis fringes not exceeding $21 a month in value, became excludable up to the same $60 monthly level as van pool benefits. Finally, in order to pay for these two new exclusions, the unlimited working condition fringe benefit for parking(3) was eliminated and replaced by a $150 monthly limitation (adjusted for cost of living) for "qualified parking." The 1992 amendment to section 132 provided that qualified transportation fringes could not be provided in lieu of salary.

Even though the purpose of the qualified transportation fringe provision was to promote mass transit, Congress amended section 132(f)(6) in 1997 to permit qualified parking to be provided to employees in lieu of salary.(4) The inequity of making this cash-option treatment available for parking, but not van pool or mass transit benefits, was remedied (retroactively) by the appropriately named Transportation Equity Act for the 21st Century.(5) In addition to permitting any qualified transportation fringe to be provided in lieu of salary, this legislation increased the base amounts for the monthly dollar limits (i.e., $65 for both van pool and mass transit benefits and $175 for parking, adjusted for cost of living).

Until January's release of proposed regulations under section 132(f), the only guidance that had been issued by Treasury was Notice 94-3, 1994-1 C.B. 327. The proposed regulations purportedly "generally conform with the guidance in Notice 94-3," as well as reflect statutory changes since 1994, and provide "additional guidance concerning the standards for determining when the section 132(f) exclusion applies to cash reimbursement of transit pass expenses."(6) Like the Notice, the proposed regulations are presented in Question-and-Answer format.

Basic Rules

The proposed regulations explain that, for purposes of determining the amount of excludable benefits, there are two categories of transportation fringe benefits: (1) transportation in a "commuter highway vehicle."(7) and transit passes;(8) and (2) qualified parking.(9) Prop. Treas. Reg. [sections] 1.132-9, Q/A 1 ("Q/A--"). For 1999 and 2000, the statutory limits for the two categories are $65 and $175, respectively.(10) An employee may receive benefits from each category, which means that for 2000 an employee may receive $240 a month in tax-free qualified transportation fringes.(11) The value of benefits exceeding the sum of the amount, if any, paid by the employee and the applicable amount excludable under section 132(f) must be included in the employee's wages for income and employment tax purposes. Q/A 8.

Qualified transportation fringes may be provided only to "employees," which for this purpose is limited to common law employees and other statutory employees, such as officers of a corporation. Thus, individuals who are partners, sole proprietors, independent contractors, and two-percent shareholders of S corporations (regardless of the fact that the two-percent shareholders may also be employees of the corporation) are not employees for purposes of section 132(f) of the Code. Q/As 5 and 24.

Although the employer's plan does not need to be in writing, the information required for a salary reduction election must be in writing or in another permanent or verifiable form. Q/A 12(a). Benefits under a qualified transportation assistance plan are not subject to any special information reporting requirements, with respect either to benefits provided to individual participants or to aggregate benefits (like health care or educational assistance).

Rules for Calculating the Statutory Limitations

Q/A 9 of the proposed regulations provides that the value of a qualified transportation fringe must be calculated on a monthly basis to determine whether the benefit has exceeded the applicable statutory monthly limit. The monthly exclusion amounts may not be combined to provide a benefit in any month exceeding the statutory limit. In the case of in-kind transit benefits other than those provided through salary reduction, however, Q/A 9 offers the following generous rule:

   In the case, of a transit pass, the applicable statutory limit applies to
   the transit passes provided by the employer to the employee in a month for
   that month or for any previous month in the calendar year.

(Emphasis added.) This ability to offer in-kind transit passes on a look-back basis is discussed in Example 2 of Q/A 9, where Employee F, who was hired in January, receives tax-free transit passes in March totaling $195 (3 months times $65).(12) The example warns that this tax-free treatment would not have applied to the issuance of transit passes for January and February had Employee F not been an employee during those months. But the rule in Q/A 9, when coupled with Q/A 18,(13) enables an employer to issue transit passes to an employee for any previous month in the year in which the employee was actually employed without having to require certification by the employee regarding his commuting use of the transit pass. In other words, Q/As 9 and 18 enable employers, at the end of the year, to hand out transit passes (not exceeding the statutory monthly limit) to each employee for each month of service during the year and exclude the collective value of the transit passes from income (i.e., $780 worth of transit passes in 2000 for an employee working the entire year). Because the employee does not have to certify that he incurred mass transit expenses, he is apparently free to dispose of the passes as he sees fit--use them himself, give them to friends or family, or even sell them.

The absence of any prohibition on subsequent sale is in contrast to longstanding rules in other employee compensation provisions that trigger immediate income (and deny any otherwise available tax exclusion), if an employee sells property before it is vested.(14) The IRS attorneys who have spent two years drafting these proposed regulations may well claim that they never intended this result, but it is likely that employers will try to take advantage of this planning opportunity where no specific prohibition on such year-end tax-exempt "transit pass bonuses" exists.

Compensation Reduction Agreements

Under amended section 132(f)(4), the employer is permitted to offer employees a choice between cash compensation and any qualified transportation fringe pursuant to a compensation reduction arrangement. Specifically, the employee has the right to elect whether he or she will receive either a fixed amount of cash compensation at a specified future date or a fixed amount of qualified transportation fringes to be provided for a specified future period (such as parking to be used in a future month). Q/A 12.

Mechanics of the Election

The reduction election must either be a fixed dollar amount or fixed percentage of compensation. The election to reduce compensation may be automatically renewable for later periods. Employers are even permitted to establish negative elections, whereby the reduction election is deemed to have been made if the employee does not notify the employer within an adequate notice period that he or she chooses to receive cash in lieu of the qualified transportation fringe. Q/A 12.

The compensation reduction election must be made before the employee is able to receive the compensation and before the period in which the qualified transportation fringe will be provided. For this purpose, the date a qualified transportation fringe is treated as being provided is the date on which the employee receives the voucher or the date on which the benefit is used. Q/A 14(a). The employee can change the election prospectively, however. Q/A 14(c).

A couple of observations concerning these rules are in order. First, it is curious that the IRS has been so liberal in permitting salary reduction elections at any time before the qualified transportation fringe is to be provided for a specified future period, i.e., even the day before the period is scheduled to begin. Under longstanding IRS ruling policies on deadlines for deferring compensation, salary deferral elections are usually required to be made in the calendar year before the services are performed.(15) Second, it is equally curious as a policy matter that the IRS has drawn a distinction between benefits paid for by salary reduction and those provided by the employer directly. Under case law, if a salary reduction election is effective because it is made before the services generating the compensation are performed, the compensation should be treated the same way as any other employer-provided compensation. Thus, under this logic, if the employee has elected to reduce compensation by $240 month (to cover both parking and van pool or mass transit benefits) in each of the last three months of 2000, the employer should be able to hand out $720 in transit passes at year end for 2000, assuming the employee was employed during the entire year. The proposed regulations, however, limit the amount of in-kind transit passes that can be distributed at year-end to $65 a month for the last three months of the year, forcing a carryover of the excess election amounts.

Revocation of a Salary Reduction Election

The proposed regulations preclude the employee from revoking the election after the employee is able currently to receive the taxable compensation or after the beginning of the period for which the qualified transportation fringe will be provided. Q/A 14(c). If the employee attempts to revoke the election during either of these periods, the employee is not permitted to receive the compensation subsequently in cash or any form other than by payment of a qualified transportation fringe. Therefore, if the employee quits working for the employer, the employer may not refund in cash any reduction amounts exceeding the actual qualified transportation fringes provided to the employee during his employment. Q/A 14(d). Of course, the former employee may submit a request for reimbursement of qualified transportation expenses incurred before termination of employment and during the period covered by the election.

Planning idea: To simplify and expedite employees' ability to revoke prior salary reduction elections, employers should consider specifying that the period of provision of benefits is a relatively short one, such as a calendar month. Otherwise, if the "period of benefit provision" is deemed to extend for a long period of time, such as a calendar quarter, it may be difficult for the employee to revoke a prior election. This is because, as a technical matter, it may be difficult to determine when precisely the period of provision of benefits starts and ends, during which (per the proposed regulations) salary reduction elections cannot be revoked.

Apart from the possible difficulty of identifying the "period of provision," the IRS's liberality in permitting prospective salary reduction elections changes stands in striking contrast to the very limited "family status change" conditions under which employees are permitted to change their salary reduction elections under cafeteria plans. These generous transit pass rules may prompt employees to complain even more frequently about the extremely limited conditions under which they can change their cafeteria plan elections.

Carryover of Excess Election Amounts

An employee may carry over unused compensation reduction amounts to subsequent periods under the plan, including periods beyond the calendar year. These carry-over amounts may be used to reimburse the employee for qualified transportation expenses incurred in a later month, so long as the reimbursement does not exceed the applicable statutory monthly limit or the amount of expenses actually incurred during the month of reimbursement. Q/A 15. Thus, if the employee does not use up the entire salary reduction amount in any given month, the unused amounts may be carried over to future months, but may only be used to pay "qualified transportation fringes."

Since the term "qualified transportation fringes" covers transit passes, it appears that an employer can zero out an employee's account at any point in time (e.g., at termination of employment) by handing out transit passes equal to the carryover amount. This would also work in situations where the excess is carried over to the next calendar year.

Assume that an employee elected to reduce salary beginning in September 2000 by $240 a month to pay for parking and van pool benefits. Further assume that by December 2000, the employee has $720 in his salary reduction account, but for some reason has only incurred van pool expenses in those months. The employer makes its fourth quarter reimbursements at the end of December and is permitted to reimburse a total of $195 ($65 times three months). The employee is permitted to carryover $480 in his account to 2001. If the employee were to decide to leave at the end of January 2001, the employer could give the employee transit passes equaling $480 and exclude $65 of that amount from income (for qualified benefits in January, because of his employment during that month) and tax the balance ($415) as wages subject to employment taxes.

This surprising rule (like the liberal changes in salary reduction election changes) stands in striking contrast to the very strict "use it or lose it" rule governing cafeteria plan benefits, and to the "no cash or taxable personal benefit option" applicable to section 62(c) business expense reimbursement plans (i.e., "accountable plans"). Plan administrators will no doubt have a difficult time justifying to employees why those rules continue to be so harsh, when such liberal carryover rules apply to transportation fringes.

Expense Reimbursements

Reimbursements for expenses incurred for transportation in a commuter highway vehicle, qualified parking, or transit passes (not subject to the special transit pass rule discussed below) must be made under "a bona fide reimbursement arrangement" meeting certain conditions. Cash advances are not permitted. Q/A 16(a).

Special Rule for Transit Passes

Consistent with the guidance in Notice 94-3, the proposed regulations permit cash reimbursements for transit passes "only if no voucher or similar item that may be exchanged only for a transit pass is readily available for direct distribution by the employer to employees." Q/A 16(b). A voucher is "readily available" if the employer can obtain it on terms no less favorable than those available to an individual employee and without incurring a significant administrative cost.(16) Notice 94-3 had failed to define what was meant by the term "significant administrative cost." The proposed regulations specify that these costs relate only to fees paid to fare media providers and the determination whether obtaining a voucher would result in a significant administrative cost must be made with respect to each transit system voucher. The costs are significant "if the average monthly administrative costs incurred by the employer for a voucher (disregarding delivery charges imposed by the fare media provider to the extent not in excess of $15 per order) are more than 1 percent of the average monthly value of the vouchers for a system." Q/A 16(c).

This one-percent rule appears to be computed by reference to the value of the passes, taking into account any discounts offered to individual riders. For example, in the Washington, D.C., Metro system, a rider can purchase a $21 fare card for $20. (Payments less than $20 do not receive a discount.) If Metro were to charge an employer more than $20.20 for each fare card (plus a handling fee of no greater than $15 per order), the employer could reimburse the employees in cash for their individually purchased fare cards under a bona fide reimbursement arrangement.

Substantiation Requirements for a Bona Fide Reimbursement Arrangement

The proposed regulations state that the facts and circumstances (including the method of payment utilized within the mass transit system) will determine whether a reimbursement arrangement is "bona fide." The employer is instructed to implement reasonable procedures to ensure that an amount equal to the reimbursement was incurred for the qualified transportation fringe. Several examples of reasonable procedures are given. The employee may submit a parking expense receipt and certify that the expense was in fact incurred for qualified parking. The reimbursement is treated as bona fide if the employer has no reason to doubt the employee's certification. Likewise, the employee may submit a used transit pass at the end of the month and certify that he or she purchased it and used it during the month. Alternatively, the employee may present an unused transit pass at the beginning of the month and certify that it will be used during the month for commuting. Finally, the proposed regulations permit an employee to certify the type and amount of expenses incurred for qualified transportation fringes for which no receipt is provided in the ordinary course of business (such as metered parking). Q/A 16. The employer is permitted, however, to implement stricter substantiation requirements than those described in the proposed regulations. Q/A 19.

Cash Reimbursements for Periods Longer Than a Month

An employer may make cash reimbursements for costs incurred for qualified transportation fringes in more than one month, as long as the reimbursement for each month is calculated separately and neither exceeds the applicable statutory monthly limit nor violates the terms of any salary reduction election.(17) Q/A 17. Thus, if an employer wants to reimburse expenses less frequently than monthly, it is permitted to do so and is even permitted to do so in the following calendar year. Surprisingly, the regulations do not adopt the time limitations used in the section 62(c) accountable plan rules, which also permit employee business expense reimbursements to be made in a subsequent calendar year provided the expenses are substantiated within a reasonable period of time. See generally Treas. Reg. [sections] 1.62-2.

Substantiation Requirements for Transit Passes Distributed by the Employer

The proposed regulations do not require any certification by the employee regarding, the use of any transit pass distributed by the employer. Q/A 18. In light of this generous rule and the hassles associated with certifying the use of transit passes, employers may want to consider not reimbursing transit benefits in cash at all.

Parking

One of the most notable differences between Notice 94-3 and the proposed regulations is the revised thinking with respect to parking valuation. Sensibly, Q/A 20 defaults to the general valuation rule for fringe benefits found in the regulations under section 61 of the Code, i.e., the value of parking is based on the cost that an individual would incur in an arm's-length transaction to obtain parking at the same site. Other than referring to the general valuation rules, no other explanation or examples are given in the proposed regulations. In contrast, much discussion was devoted to parking in Notice 94- 3, because of concern about the value of reserved parking being higher because of its availability to the employee even when not in use. The Notice had also developed the concept of the "unreserved" reserved parking space as a method of reducing fair market value, presumably to address the problem that the 79 reserved parking spaces used by IRS executives underneath the IRS National Office (as well as the underground parking used by congressional members on Capitol Hill) exceeded the then-applicable statutory monthly limitation of $155 by some $150-200 a month.(18) To reduce the "fair market" value of the parking at its National Office, the IRS decided to redesignate all of its 79 reserved indoor parking spaces as unreserved, even though permits to park in the underground facility were still limited to the same 79 IRS officials.

When asked about the proposed regulations' failure to address the employee's access to a reserved parking space as affecting the benefit's valuation,(19) one Treasury official has stated informally that it was not the IRS's intention to dismiss that factor as important when determining value. Therefore, until the regulations become final, it is not clear how much weight employers should give to the very detailed explanation of valuation set forth in Notice 94-3.

Van Pool Benefits

Q/A 21 of the proposed regulations essentially adopts the approach set from in Notice 94-3 when discussing how section 132(f) should be applied to van pool benefits. Van pools may be employer-operated, employee-operated (as long as the vehicle qualifies as a "commuter highway vehicle") or private or public transit-operated. Valuation of the benefits may be determined by using one of the special vehicle valuation rules set forth in Treas. Reg. [sections] 1.61-21, i.e., the automobile lease valuation rule, the cents-per-mile rule, or the commuting ($1.50 per one-way trip) valuation rule. Finally, Q/A 21 adopts the qualified parking prime member rule, whereby one employee in a car or van pool receiving a qualified parking space must be designated at the "prime member" for tax purposes.

Additional Issues

In the benefits area, it is not uncommon for proposed regulations to give immediate effective dates or at least indicate that compliance with the proposed regulations will be viewed as evidence of good faith until final regulations are issued. Amazingly, these new regulations provide no effective date whatsoever, or any indication at all on whether taxpayers can rely on these rules for months and years before the rules take effect. By contrast, Notice 94-3 had provided a transition rule for benefits provided before April 1, 1994, i.e., "efforts to comply with section 132(f) of the Code and to determine the fair market value of benefits that differ from the rules contained in this notice will be considered reasonable good faith compliance so long as they are based on a reasonable good faith interpretation of section 132(f)." Notice 94-3, Q/A 14.

Notice 94-3 was more concerned with substantiation requirements and valuation of qualified transportation fringes, whereas the proposed regulations focus on salary reduction arrangements as a result of changes in the law. It will be extremely difficult, however, for the IRS to refuse to apply rules at least as liberal as the proposed rules on a retroactive basis. Indeed, in the absence of any specific effective date, many taxpayers no doubt will argue that they were entitled to establish plans that are even more aggressive that those permitted under these rules (such as plans that permitted salary reduction elections at year-end and corresponding reimbursements of transportation costs, on a retroactive basis, for earlier months in the calendar year). Based on conversations with the IRS drafters of the proposed regulations, we know that they were strongly opposed to these retroactive salary reduction arrangements. The curious failure to state any effective date, however, will make it very difficult for the IRS National Office to challenge these plans on audit.

Conclusion

Even though the project is listed on the IRS's 2000 Priority Guidance Plan, employers should not be optimistic that final regulations will be issued in the near future. In fact, it is even proving difficult to get the IRS to respond to a private letter ruling request. To date, no letter rulings have been issued under section 132(f) and it is our understanding that the only pending request with the IRS is the one that was filed nearly two years ago. Thus, for the indefinite future, employers will be required to implement their qualified transportation fringe benefit plans in accordance with the rules set forth in the proposed regulations, even though numerous issues are not adequately addressed. In view of the many generous rules contained in these proposed regulations, it is likely that the number of employees who will be participating in these plans will far exceed the IRS's curiously limited estimate of "7 million taxpayers."(20) As word spreads among employee-commuters about these generous rules, they are likely to affect millions of commuters, in every city in the United States.

Notes

(1) 65 Fed. Reg. 4388 (1/27/00).

(2) Pub. L. No. 102-486, [sections] 1911.

(3) See Repealed I.R.C. [sections] 132(h)(4) and Treas. Reg. [sections] 1.132-5(p).

(4) Taxpayer Relief Act of 1997, Pub. L. No. 105-34, [sections] 1072. Surprisingly, although this change presumably will be used by mil]ions of taxpayers to reduce their taxable salaries to pay for tax-exempt transportation benefits, the change was scheduled by the congressional revenue estimators to raise revenues.

(5) Pub. L. No. 105-178, [sections] 9010.

(6) Preamble to Prop. Reg. [sections] 1.132-9.

(7) A "commuter highway vehicle" must have a seating capacity of six, excluding the driver, and at least 80 percent of the vehicle's mileage must be reasonably expected to be used in transporting commuters. I.R.C. [sections] 132(f)(5)(C) and Prop. Reg. [sections] 1.132-9, Q/A Q-2.

(8) Transit passes may be used for transportation on mass transit or in van pools.

(9) To be qualified, parking must be provided on or near the employer's premises or at a location from which the employee commutes to work in a car/van pool or by mass transit. The parking may not be on or near property used by the employee for residential purposes. Q/A 4.

(10) On January 1, 2001, the base amount for van pool and transit pass benefits will be increased to $100 per month. Pub. L. No. 107-178, [sections] 9010(c)(2); Q/A 7(a).

(11) I.R.C. [sections] 132(f)(2); Q/A 7(c).

(12) The employer cannot, however, provide the in-kind transit passes on a retroactive basis if the employee has previously made a salary reduction election for the look-bak period.

(13) Q/A 18 provides that the employee is not required to substantiate or certify his or her commuting use of any transit pass distributed by the employer.

(14) See, e.g., Treas. Reg. [sections] 1.83-1(b)(1) (triggering immediate income on the sale of substantially unvested property); Treas. Reg. [sections] 1.132-3(b)(1)(ii) (denying any exclusion under the employee discount rules where an employee disposes of discounted property other than by gift).

(15) See Rev. Proc. 2000-3, [sections] 3.01(30), 2000-1 I.R.B. 108 (Jan. 3, 2000) and Rev. Proc. 71- 19, 1999-1 C.B. 698, as amplified by Rev. Proc. 92-65, 1992-2 C.B. 428.

(16) In conjunction with the issuance of Notice 94-3, the mass-transit fare card vendors, particularly those from the metropolitan New York area, lobbied hard for this cash reimbursement limitation with respect to mass transit benefits. Their assertion that the use of third-party vendors under such circumstances would eliminate much of the IRS's concern about substantiating these types of expenses was very persuasive to the IRS officials responsible for the guidance. Legislation is still pending, however, which would completely remove the restriction on cash reimbursements for transit passes. See H.R. 3832 (designed to "help small businesses").

(17) For example, if the employer is distributing passes or making cash reimbursements because the employee has reduced salary to pay for such benefits, the amount to be excluded cannot be more retroactive than the period for which the employee first agreed to reduce salary and receive the transportation fringe.

(18) See "Washington' Taxers Find They've Taxed Themselves," New York Times, at A1 (January 6, 1994).

(19) See Notice 94-3, Q/A 10(d).

(20) See 65 Fed. Reg. 4388, 4388 (Jan. 27, 2000), estimating that 7,264,970 "respondents" (i.e., employees) would participate annually in these plans.

MARY B. HEVENER is a partner with Weil, Gotshal & Manges in Washington, D.C. Previously, she served in the Treasury Department's Office of Tax Legislative Counsel, with responsibilities in the areas of employee benefits, alternative minimum tax, employment taxes, and tax exempt organizations. She is a graduate of Wellesley College and the University of Virginia School of Law.

MARIANNA G. DYSON is a tax counsel at Weil, Gotshal & Manges in Washington, D.C. She formerly served the Internal Revenue Service as Special Assistant for Fringe Benefits. She is a graduate of the University of Louisville and the Georgetown University Law Center.