By Michael G. Kushner, Esq.
New York, NY
The Internal Revenue Service (IRS) has proposed regulations on the deductibility of employee business expenses for lodging when the employee is not traveling away from home ("local lodging"). The regulations would apply to expenses paid or incurred on or after the date they are published as final regulations in the Federal Register. Until then, taxpayers may apply the proposed regulations to expenses paid or incurred in taxable years for which the limitations period on credit or refund under §6511 has not expired.1
Regs. §1.262-1 generally disallows a deduction for local lodging expenses an employee incurs in the ordinary course of the employer's business. The proposed regulations would amend the current rules, allowing taxpayers to deduct local lodging expenses as ordinary and necessary business expenses in certain limited circumstances.
The proposed regulations follow up on Notice 2007-47,2 in which the IRS announced its plans to change the tax treatment of local lodging under Regs. §1.262-1(b)(5). Notice 2007-47 stated that, until the IRS provided further guidance, it would not challenge an employee's deduction for temporary local lodging that was necessary for the employee to participate in a business function. Specifically, the IRS said that it would not challenge the deductibility of local lodging provided by an employer or to local lodging that an employer requires an employee to obtain if (i) it is provided on a temporary basis, (ii) it is necessary for the employee to participate in or be available for a bona fide business meeting or function of the employer, and (iii) the expenses otherwise are deductible by the employee, under §162(a), or would be if paid by the employee. The proposed regulations include examples and provide more specifics.
Section 162(a) allows a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business. Generally, an expense is "ordinary" if it is normal, usual, or customary in the taxpayer's type of business. An expense is "necessary" if it is appropriate and helpful in developing the taxpayer's business.3 An expense that primarily provides an employee with a social or personal benefit or convenience, and is only secondarily related to business, however, is not "necessary."4
If an employer reimburses an employee for an expense, or an employee receives property or services resulting from an employer's payment of an expense, the federal tax treatment depends on whether the expense would have been deductible had the employee paid it directly.
Where an employee pays an expense and the employer reimburses the employee under an employer's "accountable" plan, i.e., one that requires the employee to substantiate to the employer the expense's time, place, nature, amount and business purposes, the reimbursement is not includible in the employee's income.5
Similarly, if an employer provides property or services to an employee in the ordinary course of business, the employee may be able to exclude the benefit's value from income if it qualifies as a "working condition fringe," i.e., property or services provided to an employee to the extent that, if the employee paid for the property or services, the employee could deduct the payment under §162 or §167.6
Historically, an employee's personal, living or family expenses generally were not deductible as employee business expenses.7 For example, that the costs of an employee's meals incurred when not traveling away from home ("local meals") generally were nondeductible personal expenses unless they otherwise qualified as ordinary and necessary business expenses or expenses incurred for the production of income. Former law was even stricter with respect to the deduction of local lodging expenses, treating them as nondeductible personal expenses whether or not they otherwise qualified as trade or business expenses or expenses incurred in the production of income.8 As a result, under former law, local lodging expenses reimbursed by an employer were treated as compensation income to the employee.9
The Proposed Regulations
The proposed regulations incorporate and expand upon the principles of Notice 2007-47, providing that whether local lodging expenses are incurred in carrying on a taxpayer's trade or business is to be determined based upon all of the surrounding facts and circumstances.
The proposed regulations also provide a safe harbor, under which an employee can deduct local lodging expenses if: (i) the lodging is necessary for the individual to participate fully or to be available for a bona fide business meeting, conference, training activity, or other function, (ii) the period during which such local lodging is provided does not exceed five calendar days and does not recur more than once per calendar quarter, (iii) the employer requires the employee to remain at the activity or function overnight and (iv) the lodging is not lavish or extravagant and does not provide a significant element of personal pleasure, recreation or benefit.
In the preamble to the proposed regulations, the IRS explains that the following reasons for using local lodging are considered personal and not business-related: (i) a weekend at a luxury hotel provided by the employer; (ii) lodging provided to allow an employee to avoid having to make a long-distance commute; (iii) lodging provided because the employee is required to work overtime; (iv) temporary housing for a relocated employee; and (v) lodging for an employee's indefinite personal use. In these circumstances, the expenses are not deductible by the employee, and are treated as compensation income if paid by the employer.
Employers can deduct their costs of providing local lodging in such situations as compensation for services, subject to the Code's rules on reasonable compensation.10 Because the lodging's primary purpose in such situations is to provide a personal benefit to the employee, however, if the employee personally pays the cost, he or she cannot deduct it as an ordinary and necessary business expense and must include any reimbursements in income, i.e., the employee cannot exclude it as a "working conditions fringe."
In addition to delineating situations where the provision of local lodging constitutes a personal benefit to the employee, the proposed regulations provide numerous examples of situations where the expenses are considered to be primarily for business purposes, allowing employees to deduct such expenses if paid personally or to treat an employer payment or reimbursement as nontaxable. These situations include local lodging provided (i) to enable the employee to attend employer-mandated training at a local hotel, (ii) to house athletes for last-minute training and ensure the players' preparedness for an upcoming athletic event and (iii) to house an employee who is on call to respond to business emergencies outside of normal working hours.
In such cases, the lodging's cost is primarily for the employer's business purposes rather than to provide a personal benefit to the employee. An employee therefore could deduct the cost of such local lodging as a business expense if he or she paid the cost personally or could exclude such amounts from income if the amounts were paid under an employer's accountable plan.
While the proposed regulations will be greeted positively by both employers and employees, insofar as they recognize the business aspects of many legitimate activities that are now conducted in a central location locally, the proposed regulations also require employers to establish criteria for determining what constitutes a legitimate local lodging expense. Employers will need to consider whether such expenses are primarily business in nature or are primarily for the personal benefit to the employee(s) involved and may wish to ensure uniformity and compliance with the proposed regulations by adopting and promulgating written guidelines that will enable both internal and external business event planners to distinguish between local lodging expenses that are primarily business in nature and those that are primarily personal in nature, to help assure favorable tax treatment.
For more information, in the Tax Management Portfolios, see Stechel, 519 T.M., Travel and Transportation Expenses - Deduction and Recordkeeping Requirements, and Stechel, 520 T.M., Entertainment, Meals, Gifts and Lodging - Deduction and Recordkeeping Requirements, and in Tax Practice Series, see ¶2130, Employee-Related Expenses, and ¶2310, Travel and Transportation Expenses.
4 See Comr. v. Flowers, 326 U.S. 465 (1946) (a taxpayer's expenses for lodging near his principal work location, to avoid a long commute to and from home, were nondeductible personal expenses incurred solely due to the taxpayer's decision to maintain his home far from his work location).
5 See §62(a)(2)(A) and (c). Reimbursements are treated as made under an accountable plan if they are for expenses that the employee could deduct if he or she had paid them directly under §§161 through 199, without taking into account the 2% of adjusted gross income threshold on miscellaneous itemized deductions of §67.
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