Furnishing products for employee testing.

In Letter Ruling (TAM) 9401002, the IRS has ruled that a program under which a group of employees--only 7.03% of whom were nonhighly compensated employees--received and tested several of the employer's products during the year, and were required to purchase one of the tested products during the year, did not qualify as a product testing program under Temp. Regs. Sec. 1.132-5T(n). Therefore, the value of the use of the products was income to the employees. The Service also tentatively concluded that the employer should have withheld for the value of the products, but left the employer a chance to develop further evidence that it reasonably believed that use of the products was excludible from the employees' income.

Because this ruling arose in 1987 and involved products tested in 1985, the IRS applied Temp. Regs. Sec. 1.132-5T(n) (which was effective for 1985 through 1988) rather than the final regulations (which became effective as of Jan. 1, 1989). However, final Regs. Sec. 1.132-5(n) (dealing with product testing) is substantially the same as Temp. Regs. Sec. 1.132-5T(n).

Employers that currently provide big-ticket items--cars, computers, etc.--only to upper level employees for testing should be aware of this ruling. At a minimum, they should be able to provide the evidence TAM 9401002 suggests is required to have a testing program that satisfies the requirements of the regulations.

Income inclusion

Temp. Regs. Sec. 1.132-5T(n)(1) provides that the value of the use of consumer goods provided to employees under a product testing program may be excluded from gross income as a working condition fringe if all of the following conditions are met:

1. Consumer testing and evaluation of the product is an ordinary and necessary business expense of the employer.

2. Business reasons necessitate that the testing and evaluation of the product be performed off the employer's business premises by employees (i.e., the testing and evaluation cannot be carried out adequately in the employer's office or in laboratory testing facilities).

3. The product is furnished to the employee for purposes of testing and evaluation.

4. The product is made available to the employee for no longer than necessary to test and evaluate its performance, and must be returned to the employer at completion of the testing and evaluation period.

5. The employer imposes limitations on the employee's use of the product which significantly reduce the value of any personal benefit to the employee.

6. The employee must submit detailed reports to the employer on the testing and evaluation.

The Service agreed that the program in TAM 9401002 met requirements #1, 2 and 4, but found that it did not meet the others; thus, the program did not qualify for exclusion as a working condition fringe benefit.

The IRS stated that a "discriminating classification" may be considered when determining whether a program has a testing and evaluation purpose (requirement #3) rather than a compensatory purpose. According to the Service, the low number of non-highly compensated employees included in the program, as well as other available data, suggested that the purpose of the program was to furnish products to the company's most highly compensated employees as part of an overall compensation package.

The IRS also found that the employer did not impose limitations on the employees' use of the products significantly reducing the value of any personal benefit to them, as required in requirement #5. For example, the employer noted that family use of the product was discouraged, but there was no prohibition against such use. Finally, requirement #6 was not satisfied because the employees were required only to fill out two one-page reports asking for rankings based on a scale of 1 to 5.

Withholding 

The Service then considered whether the employer should have withheld for the value of the products' use. For Federal income tax withholding purposes, Sec. 3401(a)(19) provides an exception from the definition of "wages" for any benefit provided to an employee if at the time the benefit is provided it is reasonable to believe the employee will be able to exclude it from income under Sec. 132.

The employer argued that it reasonably believed that the fringe benefit would be excludible from the employees' gross income under Sec. 132; therefore, the value was not included in the employees' "wages" for income tax withholding purposes. The employer argued that during the legislative process leading up to the adoption of Sec. 132 in the Deficit Reduction Act of 1984, it had described its product testing program to members of Congress and staff and was assured that Sec. 132 would govern such benefits. However, the IRS stated that it was not clear that the employer adequately or accurately described the program to the congressional representatives.

According to the Service, the record indicated that during 1985, the company made a series of modifications and changes to its program that appeared to address issues in the legislative history--which suggested that the employer did not have a reasonable belief on Jan. 1, 1985 that employees receiving the benefit would be able to exclude its value from income under Sec. 132. The IRS concluded by stating that whether or not the employer could demonstrate it had a basis for reasonably believing it met the requirements for exclusion at some point in 1985 as a result of changes and modifications to its testing program was a factual matter requiring additional discussion between the employer and the examining agent.