Proposed Regs Clarify Tax Treatment of Employer Reimbursement Arrangements between Three Parties (Parker's Federal Tax Bulletin: August 2012)

In recent years, many small and medium-sized companies have sought to reduce their overall labor costs by contracting with a professional employer organization (PEO) to provide essential services such as administrating employee benefit plans and paying employees, employment taxes, and workers compensation premiums. Several tax issues have arisen as a result of using these organizations. One of the more complex issues deals with how the deduction limitation rules of Code Sec. 274 apply. The IRS has now issued proposed regulations (REG-101812-07 (7/31/12)) that clarify the definition of reimbursement or other expense allowance arrangement for purposes of determining how the deduction limitations apply to reimbursement arrangements between three parties.

       Practice Tip: While the regulations are proposed to apply to expenses paid or incurred in tax years
       beginning on or after the date the regulations are finalized, the IRS is allowing taxpayers to apply
       the proposed regulations currently and to apply them to any tax years for which the statute of
       limitations is still open.

Background

Code Sec. 274(a)(1) limits deductions for certain expenses for entertainment, amusement, or recreation activities and for facilities used in connection with entertainment, amusement, or recreation activities. Code Sec. 274(n)(1) generally limits the amount allowable as a deduction for any expense for food, beverages, entertainment activities, or entertainment facilities to 50 percent of the amount otherwise allowable. However, the limitations of Code Sec. 274(a)(1) and Code Sec. 274(n)(1) do not apply to an expense described in Code Sec. 274(e)(3).

In general, Code Sec. 274(e)(3) excepts from the limitations of Code Sec. 274(a) expenses a taxpayer pays or incurs in performing services for another person under a reimbursement or other expense allowance arrangement with the other person. Under Code Sec. 274(e)(3)(A), the exception applies if the taxpayer is an employee performing services for an employer and the employer does not treat the reimbursement for the expenses as compensation and wages to the taxpayer. In that case, the employee is not treated as having additional compensation and has no deduction for the expense. The employer bears and deducts the expense and is subject to the deduction limitations.

If the employer treats the reimbursement as compensation and wages, the employee may be able to deduct the expense as an employee business expense. Under Reg. Sec. 1.274-2(f)(2)(iv)(b), the employee bears the expense and is subject to the deduction limitations, while the employer deducts an expense for compensation, which is not subject to the deduction limitations.

Under Code Sec. 274(e)(3)(B), the Code Sec. 274(e)(3) exception also applies if the taxpayer performs services for a person other than an employer and the taxpayer accounts (i.e., substantiates) to that person. Therefore, in a reimbursement or other expense allowance arrangement in which a client or customer reimburses the expenses of an independent contractor, the deduction limitations do not apply to the independent contractor to the extent the independent contractor accounts to the client by substantiating the expenses. Reg. Sec. 1.274-2(f)(2)(iv) provides that, if the independent contractor is subject to the deduction limitations, the limitations do not apply to the client.

Transport Labor Contract/Leasing Decision

The proposed regulations address situations similar to the scenario in Transport Labor Contract/Leasing, Inc. v. Comm'r, 461 F.3d 1030 (8th Cir. 2006), rev'g 123 T.C. 154 (2004). In that case, Transport Labor Contract/Leasing, Inc. (TLC) provided PEO services by hiring truck drivers as its employees and then leasing them to its trucking company clients. TLC paid truck drivers a per diem allowance that it did not treat as compensation. It billed the client leasing the drivers for the drivers' wages and per diem allowances, and the client paid TLC. TLC provided its clients with the expense substantiation information required by Code Sec. 274(d). The Tax Court applied the Code Sec. 274(n) limitation to TLC as the drivers' common law employer.

The Eighth Circuit reversed, stating that the Tax Court should have considered Code Sec. 274(e)(3)(B). In determining who the Code Sec. 274(n) limitation applied to, the Eighth Circuit said that because TLC's per diem payments were not treated as truck driver wages, the limitation did not apply to the drivers. Thus, the question then was whether the limitation applied to TLC or the trucking companies. The Eighth Circuit concluded that because TLC paid per diem expenses to the truck drivers and provided the trucking company clients with the expense substantiation information required by Code Sec. 274(d), the trucking companies were subject to the limitation. The court also noted that there was substantial documentary evidence establishing that TLC and its clients entered into a reimbursement or other expense allowance arrangement that satisfied the requirements of Reg. Sec. 1.62-2(c) through (f) and, therefore, satisfied Code Sec. 274(e)(3).

Revenue Ruling 2008-23

In Rev. Rul. 2008-23, the IRS acquiesced to the result in the TLC decision and similarly held that the party that ultimately bears the expense in a three-party reimbursement arrangement is subject to the Code Sec. 274(n) limitation. The revenue ruling clarified that a party's status as a common law employer is not relevant to the Code Sec. 274(n) analysis, which the Eighth Circuit's opinion could be read to imply.

Rev. Rul. 2008-23 clarified another issue raised by the TLC opinion. To define the term reimbursement or other expense allowance arrangement for purposes of Code Sec. 274(e)(3), the Eighth Circuit looked to Reg. Sec. 1.274-2(f)(2)(iv)(a), which provides that the term reimbursement or other expense allowance arrangement in Code Sec. 274(e)(3) has the same meaning as in Code Sec. 62(a)(2)(A) (dealing with employee business expenses and previously labeled 62(2)(A), but without regard to whether the taxpayer is an employee of the person for whom the taxpayer provides services. Thus, the court defined reimbursement or other expense allowance arrangement for purposes of Code Sec. 274(e)(3) by reference to Code Sec. 62(a)(2)(A) and Reg. Sec. 1.62-2, which provide the rules for the employee reimbursement arrangements called accountable plans.

According to the IRS, the TLC court's definition was inaccurate to the extent it relied on the accountable plan rules, which cover employee reimbursement arrangements only, in determining the existence of a reimbursement or other expense allowance arrangement for purposes of identifying who bears the expense under Code Sec. 274(e)(3)(B).

Thus, Rev. Rul. 2008-23 clarified that the Reg. Sec. 1.274-2(f)(2)(iv)(a) reference to Code Sec. 62(a)(2)(A) predated the enactment of Code Sec. 62(c), which addresses certain arrangements not treated as reimbursement arrangements, and the accountable plan regulations, which govern employer-employee reimbursement arrangements and their employment tax consequences. Therefore, Rev. Rul. 2008-23 holds that the Code Sec. 274(e)(3) exception may apply to an expense reimbursement arrangement without regard to whether it is an accountable plan.

Prop. Regs Define Reimbursement or Other Expense Allowance Arrangement

In the preamble to the proposed regulations, the IRS states that the focus of the accountable plan rules under Code Sec. 62(c) and the applicable regulations is the taxability of reimbursements and allowances paid to employees and their treatment for employment tax purposes. The purpose of the rules under Code Sec. 274(e)(3), the IRS notes, is to provide an exception to the Code Sec. 274(a) and (n) deduction limitations. Given these different purposes, the proposed regulations amend Reg. Sec. 1.274-2(f)(2)(iv)(a) to provide an express definition of reimbursement or other expense allowance arrangement for purposes of Code Sec. 274(e)(3), independent of the definition in Code Sec. 62(c).

Under the proposed regulations, a reimbursement or other expense allowance arrangement involving employees is an arrangement under which an employee receives an advance, allowance, or reimbursement from a payor (the employer, its agent, or a third party) for expenses the employee pays or incurs in performing services as an employee. A reimbursement or other expense allowance arrangement involving persons that are not employees is an arrangement under which an independent contractor receives an advance, allowance, or reimbursement from a client or customer for expenses the independent contractor pays or incurs in performing services if either:

(1) a written agreement between the parties expressly provides that the client or customer will reimburse the independent contractor for expenses that are subject to the deduction limitations; or

(2) a written agreement between the parties expressly identifies the party that is subject to the Code Sec. 274(n) limitations.

       Observation: The IRS is looking for specific comments on the definition of reimbursement or other
      expense allowance arrangement and on alternative definitions or approaches that would ensure that
      the deduction limitations apply to one of the parties to an expense reimbursement arrangement.

Rules for Two-Party Reimbursement Arrangements Clarified

The proposed regulations clarify that the rules for applying the exceptions to the Code Sec. 274(a) and (n) deduction limitations apply to reimbursement or other expense allowance arrangements with employees, whether or not a payor is an employer. Under the proposed regulations, a payor includes an employer, an agent of the employer, or a third party. For example, either an independent contractor or a client or customer may be a payor of a reimbursement arrangement. Thus, any party that reimburses an employee is a payor and bears the expense if the payment is not treated as compensation and wages to the employee.

The proposed regulations also address situations where a reimbursement or other expense allowance arrangement between an independent contractor and a client or customer includes an agreement expressly providing that the client or customer will reimburse the independent contractor for expenses that are subject to the deduction limitations. In that case, the deduction limitations do not apply to an independent contractor that accounts to the client within the meaning of Code Sec. 274(d) and the associated regulations, but they do apply to the independent contractor and not to the client if the independent contractor fails to account to the client. Alternatively, the parties may enter into an express agreement identifying the party that is subject to the deduction limitations.

Multiple-Party Reimbursement Arrangements Analyzed Separately

Under the proposed regulations, multiple-party reimbursement arrangements are separately analyzed as a series of two-party reimbursement arrangements. Thus, for example, an arrangement in which (1) an employee pays or incurs an expense subject to limitation, (2) the employee is reimbursed for that expense by another party (the initial payor), and (3) a third party reimburses the initial payor's payment to the employee, is analyzed as two two-party reimbursement arrangements. One arrangement is that between the employee and the initial payor, and another arrangement is that between the initial payor and the third party.

Example 1: Nancy, an employee, performs services under an arrangement in which LMN, an employee leasing company, pays Nancy a per diem allowance of $10 for each day that Nancy performs services for LMN's client, ABC, while traveling away from home. The per diem allowance is a reimbursement of travel expenses for food and beverages that Nancy pays in performing services as an employee. LMN enters into a written agreement with ABC under which ABC agrees to reimburse LMN for any substantiated reimbursements for travel expenses, including meals, that LMN pays to Nancy. The agreement does not expressly identify the party that is subject to the deduction limitations. Nancy performs services for ABC while traveling away from home for 10 days and provides LMN with substantiation that satisfies the applicable substantiation requirements of $100 of meal expenses incurred by Nancy while traveling away from home. LMN pays Nancy $100 to reimburse those expenses pursuant to their arrangement. LMN delivers a copy of Nancy's substantiation to ABC. ABC pays LMN $300, which includes $200 compensation for services and $100 as reimbursement of LMN's payment of Nancy's travel expenses for meals. Neither LMN nor ABC treats the $100 paid to Nancy as compensation or wages. In this case, Nancy and LMN have established a reimbursement or other expense allowance arrangement. Because the reimbursement payment is not treated as compensation and wages paid to Nancy, she is not subject to the Code Sec. 274 deduction limitations. Instead, under his analysis, LMN, the payor, is subject to the deduction limitations. Because the agreement between LMN and ABC expressly states that ABC will reimburse LMN for expenses for meals incurred by employees while traveling away from home, LMN and ABC have established a reimbursement or other expense allowance arrangement. LMN accounts to ABC for ABC's reimbursement in the required manner by delivering to ABC a copy of the substantiation LMN received from Nancy. Therefore, under this analysis, ABC, and not LMN, is subject to the Code Sec. 274 deduction limitations.

Example 2: The facts are the same as in Example 1 except that, under the arrangements between Nancy and LMN and between LMN and ABC, Nancy provides the substantiation of the expenses directly to ABC, and ABC pays the per diem directly to Nancy. In this case, Nancy and ABC have established a reimbursement or other expense allowance arrangement. Because Nancy substantiates directly to ABC and the reimbursement payment was not treated as compensation and wages paid to Nancy, Nancy is not subject to the Code Sec. 274 deduction limitations. ABC, the payor, is subject to the Code Sec. 274 deduction limitations.

Example 3: The facts are the same as in Example 1, except that the written agreement between LMN and ABC expressly provides that the deduction limitations will apply to ABC. LMN and ABC have established a reimbursement or other expense allowance arrangement. Because the agreement provides that the deduction limitations apply to ABC, ABC, and not LMN, is subject to the Code Sec. 274 deduction limitations.

Example 4: The facts are the same as in Example 1, except that the agreement between LMN and ABC does not provide that ABC will reimburse LMN for travel expenses. In this case, the arrangement between LMN and ABC is not a reimbursement or other expense allowance arrangement. Therefore, even though LMN accounts to ABC for the expenses, LMN is subject to the Code Sec. 274 deduction limitations.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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