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Hitting below the line: new rules for employee business expenses.

Hitting Below the Line

Like a prize fighter reacting from a shot below the belt, the taxpayer is still reeling from the IRS roundhouse when it set the tough "below the line" rules for business deductions.(1) With the arbitrary 2% floor limitation (under Sec. 67), Congress might as well have snatched away from many the highly touted tax cuts which were handed out in the 1986 tax act.

Executives and professionals who have advanced to higher income levels (of adjusted gross income) have clearly taken most of the pummeling with the restrictive "tax floors." Not only do these individuals incur most employee business expenses, they are also the ones that have to sit back and watch their business deductions disappear under the so-called progressive tax policy. If the 2% limitations hadn't already done the trick, another 3% formulation has now been tacked on for years after 1990.(2) With a new concept referred to as a "general overall limitation on total itemized deductions" the Revenue Reconciliation Act of 1990 is ready to make one more dent in the pocketbook of the higher income professional.(3) Toward this end, Code Sec. 68 will now target will now target those whose adjusted gross income (AGI) exceeds $100,000 ($50,000 for those married filing separately).

Since employee business expenses (and other miscellaneous deductions) have already been subjected to a SPECIFIC type of limitation (i.e., the 2% floor), an obvious question has been raised in connection with the 1990 legislation and the new GENERAL limitation. Will the new law give any relief from this seeming double whammy?

Sec. 68 (d) says no deal. The 3% reduction is to be applied to the allowable itemized deductions AFTER the application of any other specific limitations.

Example: Reed had miscellaneous itemized deductions which consisted of unreimbursed travel expenses of $3,200 and professional educational expenses of $1,800. With an adjusted gross income of $200,000, the 2% specific limitation would leave Reed with only a $1,000 deduction.

The provisions of Sec. 68(d) will then cause the 3% reduction to apply against the remaining $1,000 of miscellaneous itemized deductions.

The new legislation appears to be the result of another congressional attempt to ensure that the higher wage earner doesn't walk away with a trace of tax relief for his legitimate out-of-pocket business expenses.

Not surprisingly, many higher income executives and professionals have been ducking for cover by bringing the employer into the picture in an effort to negate this seeming inequity. With creative reimbursement plans they could easily shift the business deductions to the company where they would be freed from the curtailment of all floor limitations.

This is now being accomplished with the application of Sec 62(a) (2) which, in effect, allows the employee to deduct from gross income (above the line) those employee business expenses that are reimbursed under a so-called reimbursement agreement. To understand the importance of this planning, employers and employees both need to reflect on the breadth and variety of deductions that are exposed to the so-called "below-the line" limitations. In Sec. 1.67-IT, some examples are given (but are not limited to):

"Unreimbursed employee expenses; such as, expenses for transportation, travel fares and lodging while away from home, business meals and entertainment, continuing education courses, subscriptions to professional journals, union or professional dues, professional uniforms, job hunting and the business use of the employee's home."(4)

Example: 1. If T, with an AGI of $100,000, were to spend $800 for professional books and supplies and $700 for business entertainment, he would receive no tax benefit because of the 2% limitation alone; 2. If T (above) were to arrange to have the $1,500 in business expenses reimbursed by his employer, while reducing his salary for the same amount, he would succeed in securing a 100% write-off for the expenses.

The prevailing theory is that business organizations unlike individuals have been spared. They will presumably continue to be spared from the obtrusive "below the line" floor policies. Congress has as its rationale the belief that employers will be reluctant to pay out reimbursements for expenses that are not bona fide business expenses or are not properly documented. With continuing cuts in the IRS budget and with reduced audit capabilities there seems to be a clear cut government advantage to shift the responsibility over to the employer.

To make it happen, all you have to do is to make sure that you have a workable "arrangement" as outlined in the now final regulations under Sec. 1.62-2.

Passing the Buck to the

Employer

Other Advantages

In the process of expanding upon reimbursement arrangements, many professional employees (and subscontractors) feel that they have gained another benefit for their efforts which is in addition to beating stringent floor limitations. For one thing, an advantage exists in the presumptive sense that there will be a significant reduction in the odds of being challenged by the IRS. This is certainly true as the specific employee (or subcontractor) is simply receiving payment for business expenses. It's a lot easier for one to account for business expenses to his employer, August 22, 1991, and then let that employer worry about dealing with the IRS.

Further, who can deny the advantage of bringing the resources of management into the picture to share the responsibility for dealing with the vast number of issues involving tax deductibility. With accountants and lawyers on hand to render counsel, the employer is in a better position to evaluate the technical propriety of business write-offs set in the guidelines of a near hopelessly complex Tax Code.

Typical Problem Areas With

the Use of Reimbursement

Plans

When expanding the use of reimbursement or other expense allowance arrangements, the employee needs to be reminded (by his tax adviser) that there are pitfalls for the unwary. At first blush, the business of passing the buck back to the employer might appear as a panacea against increasing floor limitations (and, perhaps, against IRS audits). But a risk is involved if a specific game plan is not followed. Moreover, that risk will be a tax trap not for the employer but for the very common employee who was designated for protection in the first place.

Sec. 1.62-2 tells why. In its final form it was made clear that reimbursement or other expenses allowance arrangements must satisfy three criteria or else it will be labeled as a "nonaccountable plan." Nonaccountable plans, it goes on to say, will require that payments/reimbursements go into the employee's gross income. (That means W-2 reporting and withholding etc. FICA, FUTA, RRTA, RURT and income tax.) If this occurs, the buck will be passed back to the employee.(5)

Put another way, failure to meet only one of the three rules will cause the employee to regain the burden of substantiating (this time to the IRS) the full amount of the employee business expenses.(6) In addition, the 2% (and 3%) limitations will enter the picture to reduce or perhaps even to wipe out entirely, the deductions for the higher income employee.

Establishing a Workable

Arrangement: Meeting the

Criteria

It is to be noted that the final form of the new regulation never really spelled out procedurally how a reimbursement or other expense allowance arrangement is to be set into motion. Instead, by definition, the statute points to the so-called arrangement as one that simply meets the requirements of three specific paragraphs (d), (e) and (f) in the new section.

Unarmed with specific guidelines, many tax advisers have used this reference as they hastened to take overt steps to help employer clients demonstrate that a proper plan exists. Some of those steps include the drafting of official policy statements and employment agreements which give definition to those now familiar three requirements needed to permit above-the-line treatment for reimbursed expenses and advances: 1. The expenses must have a business

connection ... (para d) 2. The expenses must be substantiated

fully under Section 274(d)

or be adequately identified ...

(para e) 3. Any excess reimbursements must

be returned within a reasonable

period of time ... (para f)

Attention is called to the incorrect presumption, made by many that an authoritative written document is all that is necessary to ensure the existence of a qualified plan or arrangement.

What is overlooked is the nexus of the old familiar Tax Code requirements and the referenced paragraphs (d), (e) and (f) of the new regulation. In simple language, the employer is now expected to assume the role of the IRS by ascertaining whether or not ALL of the statutory language in the Code is met before a payment in reimbursement of any business expense is made.

What we see in a close reading of 1.62-2 is an inference that the usual strict standards for ANY business deduction should be re-asserted, especially for the benefit of those who wish to draft a plan for granting reimburseable (non-taxable) payments to employees.

These standards are outlined in code sections starting from Section 161 all the way to Section 196 not to mention Section 274(d) and the recordkeeping rules. In short, if the employer fails to monitor total compliance with the usual statutory provisions, the plan is meaningless.

What is the bottom line summary of all this procedural legislation? For the higher income employee, one might note a "good news/ bad news" effect which will be triggered when a reimbursement (or expense allowance) arrangement is made under the current law.

The bad news points to the employee who has the most at risk in that he will find that he must share the responsibility for substantiating that a proper plan has been put into place. A nonaccountable plan will exact (for him alone) a heavy tax cost.

The good news is that with a proper plan in place the employee has the opportunity to save his valued business deductions. Presumably, he will receive supporting input from his employer who, with experienced advisers on hand, will help ensure that the underlying business deductions have met all the technical requirements of law. This should virtually guarantee (personal) insulation from the IRS.

In the larger sense, one other positive effect may result from the legislative action and the passing back to the employer of various business deductions. The employer, as well as the employee, may receive a much needed update on some of the basic tenets of the tax law as they deal with all business deductions.

The writer is reminded of the look of disbelief displayed by a certain marketing director who had just been apprised of the (tax deduction) rules in connection with some routine business meals that he shared with an old-established client. How was he supposed to know, he wondered, that a simple entertainment expense item would require an array of technical qualifications for deduction on his personal return?

He had wondered why nobody informed him about something called the "directly related" test(7) - a test he couldn't quite pass. It seemed he had no records to prove that: 1. The specific dinner engagements

involved an active discussion

aimed at obtaining immediate

revenue" or 2. The engagements took place in a

"clear business setting."

The look of disbelief turned into grimace when he was told that, after 1986, the special exception for "quiet business meals" (general goodwill) is no longer applicable.(8)

Grimace turned to blank stare when the director was informed about still another provision that might be used to salvage his right to claim the cost of the meals and tip. Here he was told that he would need to keep a detailed record showing that the entertainment either preceded or followed a substantial and bona fide business discussion. That is, a clear business meeting, negotiation discussion or other bona fide business transaction will have to take place for the purpose of obtaining income at one point before or after the entertainment.(9)

With this, the highly paid executive abandoned his claim. He had decided that his efforts toward substantiation would be futile and, at best, capable of generating but a miniscule saving because of the floor limitations.

Conclusion

In conclusion, employers and employees should be reminded that there are a myriad of business expenses that are subject to longstanding, special rules necessary for deduction. Entertainment, travel, business gifts, home office expense, job hunting, education and social clubs are part of the laundry list of deductions that merit special attention. Employees who incur business expenses must face the reality that the same tough standards of tax law are not about to go away simply because those expenses had been reimbursed by the employer/management. The employer might appear to be taking over the job of enforcement, but don't be surprised if IRS decides to look over his shoulder.

This is an opportunity for the professional adviser to provide valuable input. While restating some of the Tax Code requirements for specific business deduction, he could help direct the implementation of all facets of a viable plan/arrangement.

Footnotes

(1) Sec. 67(a) and (b).

(2) Revenue Reconciliation Act of 1990 - Sec. 68 IRC.

(3) S Rept p. 189.

(4) Reg. sec. 1.67 IT (a) (i).

(5) Reg. sec. 1.62-2(c) (3) (5).

(6) Reg. sec. 1.62-2(c) (3) (5).

(7) Reg. sec. 1.274-2(c) (2).

(8) Code sec. 274 (e) (1) before amend by sec. 142 (a) (2) (A), PL 99-514 10/22/86.

(9) Reg. sec. 1.274-2 (d) (1), 2, 3.

Thomas J. Stemmy, MMS, CPA, is a partner in the accouting firm of Stemmy, Tidler & Morris, P.A., in Greenbelt, Maryland. An internal revenue agent in the early 1960s, he has been in practice as a tax specialist and consultant since. A faculty member at the University of Maryland, he teaches federal taxation and has been an advisor in the cooperative education program. He is listed in Who's Who in the World and has published numerous articles for a variety of professional publications including the AICPA Planner.
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Author:Stemmy, Thomas J.
Publication:The National Public Accountant
Date:Oct 1, 1991
Words:2339
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