The high cost of subsidized eating facilities and employees eating in.

Every employer's dream is a diligent worker munching on a sandwich at his or her desk during lunch hour. Because the cost of a meal is "small potatoes" when compared to the value of a highly productive employee, employers regularly pick up lunch and dinner tabs, often assuming that this expense is not required to be included in an employee's gross income. Although they are often correct in their assumption, they do not realize that employer-provided meals must meet objective tests under the Code to be excluded. Employers might face significant exposure to additional employment taxes if they do not meet the tests.

Exclusion Tests

Sec. 119(a) is the primary authority on meals or lodging provided for an employer's convenience. Under that provision, meals furnished to an employee (or the employee's spouse or dependents) would be excluded from his or her gross income if the employer provides the meals (1) on its business premises and (2) for its convenience.

Whether meals are "convenient" is an objective determination based on the facts and circumstances. Generally, it means that employers provide meals for a substantial noncompensatory business reason, rather than as additional employee compensation.

Although Regs. Sec. 1.119-1(e) indicates that cash allowances or reimbursements for meals do not qualify for exclusion, Regs. Sec. 1.132-6(d)(2)(i)(C) provides that meal money paid on an occasional basis to an employee working overtime, is an excludible de minimis fringe benefit.

Under Regs. Sec. 1.119-1(a)(2)(ii)(a)-(f), meals are provided for a substantial noncompensatory business reason when furnished:

1. To allow an employee to be on emergency call during meal periods;

2. Because an employer's business restricts an employee to a short meal period (e.g., 30-45 minutes), and it is impossible for the employee to eat elsewhere in such a short time;

3. Because an employee cannot secure meals within a reasonable period (e.g., the vicinity has no sufficient eating facilities);

4. To a restaurant or food-service employee, irrespective of whether the employer furnishes meals during, or immediately before or after, working hours;

5. At a place of business, and the reason for furnishing meals to substantially all of the employees who are furnished the meals is a substantial noncompensatory business reason (the meals then furnished to each of the other employees will be regarded as a substantial noncompensatory business reason); and

6 Immediately after working hours, if an employee's duties prevented him or her from obtaining a meal during working hours.

Under Regs. Sec. 1.119-1(a)(2)(iii), meals would be for a compensatory business reason if they were furnished to promote the employee's morale or goodwill.

Employer Safe Harbors 

Frequently, a company has many employees; while some are entitled to the meal exclusion (e.g., hospital workers who must be available for emergencies), others are not. Keeping track of this is an onerous task. Thus, Sec. 119(b)(4) provides a safe harbor for employers: if more than one half of employees qualify for the exclusion, all such meals furnished to employees would be treated as having been provided for the employer's convenience. The value of all the meals under these circumstances would be excludible from the employees' income and deductible by the employer.

Sec. 274 sets forth rules entitling an employer to a deduction. Unless the employer meets one of the exceptions, Sec. 274(n)(1) generally limits the deduction allowance to 50% of meal costs.

If an employer does not meet the Sec. 119 convenience test, it might be able to claim a deduction if it subsidizes eating facilities for its employees. Sec. 132(e)(2) provides that an employer's operation of an eating facility will be treated as a de minimis fringe benefit if the (1) facility is on or near its business premises and (2) facility's revenues equal or exceed its direct operating costs on an annual basis; see Regs. Sec. 1.132-7(a)(1). For the exclusion to apply, Regs. Sec. 1.132-7(a)(2) states that the employer must:

1. Own or lease the facility;

2. Operate the facility;

3. Locate the facility on or near its business premises; and

4. Furnish meals during or immediately before or after the employees' workday.

Note: For this exclusion to apply, the nondiscrimination roles as to highly compensated employees must be satisfied.

If the subsidized meals do not meet either the Sec. 119 or 132(e) requirements for exclusion, the taxable value of the meals is includible in the employees' gross income and subject to FICA, FUTA and Federal income tax withholding. Further, if Sec. 132(e) does not apply, Temp. Regs. Sec. 1.61-2T(j) provides a special rule to determine the taxable value of the meals to be included in the employees' gross income. The value of all meals provided at an employer-operated eating facility will be deemed to equal 150% of the facility's direct operating costs. Under the regulation, the taxable value of the meals provided at the eating facility is then determined by the employer's choice of either an "individual meal subsidy" or a "total meal subsidy" formula.

Conclusion

If an employer has not included the value of meals in an employee's gross income subject to employment taxes, the IRS, on audit, might determine that the employer is responsible for the income tax withholding (27%, the supplemental wage withholding rate for 2002 and 2003) and the combined employee and employer share of FICA/Medicare and FUTA taxes that it should have withheld. Because the facility's direct operating costs are grossed up by 150% to determine the meals' value, the resulting additional tax assessed against the employer could be staggering. Moreover, the Service might contend that the employer's deduction for the meal subsidy is limited to 50% of cost, under Sec. 274(n).

Thus, an unsuspecting employer not otherwise entitled to exclude from its employees' gross income the cost of subsidized meals may find itself providing a very costly fringe benefit.

FROM JAMES BRENNAN, CPA, PRINCIPAL, AND NANCY CHASSMAN, J.D., LL.M., SENIOR MANAGER, IRS PRACTICE & PROCEDURE GROUP, ERNST & YOUNG LLP, NEWYORK, NY