In Short:

Expenses for hotels for employees whose home is in the same metropolitan area so that the employees can attend conferences or business meetings of the employer will no longer be taxable to the employees under new proposed regulations issued by the IRS.  This is a relaxation of a longstanding rule that such expenses were taxable.  The expenses will not be taxable if the employer requires the employee to stay away from home in order to fully participate in a bona fide business meeting, conference, training activity, or other business function. 

The Full Story:

Today’s tax quote:  “Beware of strong drink.  It can make you shoot at tax collectors, and miss.”  Lazarus Long

One reason employers and employees might have been tempted to shoot at the tax collector has been removed in new regulations. 

The Internal Revenue Service has issued a proposed regulation providing that under some circumstances lodging paid for or reimbursed by an employer to an employee who lives locally is not taxable to the employee.  The proposed regulation is at http://www.regulations.gov/#!documentDetail;D=IRS-2012-0017-0001, and is a welcome exception to the treatment as taxable of most such costs.

By way of background, traveling expenses of employees while away from home overnight on trade or business, including lodging, are deductible, and reimbursements from employers are not taxable, provided the “accountable plan” rules are met.  The accountable plan rules require in general that the employee account to the employer for actual expenses, and return any excess of advances over expenses, within a reasonable time.  However, it is also a well established principle that local travel expenses (that is, when the employee is within the general vicinity of the employee’s residence) are not deductible, and reimbursements are taxable.  For example, commuting expenses are not deductible travel expenses.  This rule generally extends to local lodging provided to the employee.  For example, a prominent Supreme Court case, Commissioner v. Flowers, holds that lodging near the employee’s work location obtained to avoid a long commute is not deductible, but is a nondeductible personal expense incurred for the convenience of the employee.  This result has been reflected for many years in section 1.262-1(b)(5) of the regulations.

The unfortunate result of this principle, however, was that if an employer insisted that an employee stay overnight at a local hotel for training or a meeting (such as a conference), the cost paid by the employer was taxable wages to the employee. 

The IRS began to reconsider this result in 2007, with issuance of Notice 2007-47.  In that Notice, IRS announced its intention to amend the regulation cited above to reflect that under some circumstances such costs were deductible by the employee, and not taxable if provided by the employer.  The circumstances recited were that the lodging is temporary, and is “necessary for the employee to participate in or be available for a bona fide business meeting or function of the employer.”  IRS said that in the interim it would not raise the issue on audit or in litigation. 

The proposed regulations, issued April 24, 2012, follow up (if somewhat belatedly) on the Notice. 

The proposed regulations establish rules to distinguish between local lodging provided for the employee’s convenience or personal benefit and lodging that would qualify as a deductible business expense if paid for by the employee.  The issue is ultimately a question of fact.  However, the regulations provide that a prominent factor is whether the employee incurs the expense because of a “bona fide condition or requirement of employment imposed by the taxpayer’s employer.”  The regulations also provide a “safe harbor” that may be relied upon to establish that such expenses are deductible/excludable.

The safe harbor says that if the lodging is necessary for the individual to participate fully in or be available for a bona fide business meeting, conference, training activity, or other business function; is for a period not exceeding five days and does not occur more often that once per calendar quarter; the employer requires the employee to remain at the activity or function overnight; and the lodging is not lavish or extravagant and does not provide any significant element of personal pleasure, recreation, or benefit, then the lodging is not taxable to the employee.

The regulation goes on to provide a number of examples illustrating the rule.  One of them makes clear that the lodging is still taxable if the employer pays for lodging near the office to enable the employee to maximize time on a project and avoid a two-hour commute. 

Although the regulations are merely proposed, and will not be effective until final regulations are published, IRS also provided that taxpayers may apply the proposed regulations to any expenses for any open year. 

The new regulations are a welcome relaxation of what many believed to be an unrealistic and unfair application of the tax law to situations in which employees were clearly incurring costs for business reasons, but were not allowed to deduct them.  However, both employers and employees should note carefully that the relaxation only goes so far.  If an employer and employee wish to take advantage of the new rules, the employer must require the employee to be physically present at the overnight lodging, and there must be a good reason why the employee’s presence there is necessary other that to facilitate the employee’s work schedule and commute (see the example recited above). 

Comments on the proposed regulation are due by July 24, 2012.

Posted by Peter K. Scott