What do you call expenses you pay in the course of your work that are not reimbursed by your employer? The IRS calls them employee business expenses, and the tax code provides for an itemized deduction (code section 62(a)(1)) subject to a 2% haircut. But what if your employer is the public? Do the same rules apply?
In general, the answer is yes, federal tax requirements generally apply in the same way…but not always. For example, in the weeds of code section 62 lies an exception for “certain expenses of officials.” The exception applies to fee-based public officials (individuals who receive and retain payment directly from the public), and provides for an above-the-line deduction for expenses the officials pay out of pocket.
The exception was added to the internal revenue code by the Taxpayer Relief Act of 1997. Congressional intent was to allow certain state and local government officials who hired employees and incurred expenses in connection with official duties to deduct those expenses without having to reduce them by the 2% floor on itemized deductions. (See office of chief counsel memorandum 199939001.)
In 146 T.C. No. 3 (Jones), the taxpayer was a judge in Arizona. The court for which he worked was funded in part by fees such as those from case and document filings, petitions, writs, and the issuance of licenses or certificates. The taxpayer could charge, and keep, fees for wedding ceremonies.
The taxpayer was paid a regular salary that was funded equally by the county’s general fund and by the state. He received regular paychecks with federal and state income tax withheld, and a Form W-2 at the end of every year. He was also eligible for benefits provided by the state or the county, whichever he choose. He was informed yearly how much fee revenue was paid to fund the retirement plan, and he started receiving payments from the plan after his retirement in 2012.
When budget cuts went into effect, the taxpayer began paying some expenses himself. He decorated his office for pretrial conferences that were held in his chambers; he bought a new computer monitor for his courtroom; he bought gift cards for high performing members of his staff; he paid personally to attend legal seminars.
On the advice of his CPA, the taxpayer deducted the expenses above-the-line on his tax return (as opposed to taking an itemized deduction). He believed the treatment was correct because he was, at least in part, a fee-based public official.
The IRS agreed that the taxpayer was an employee of Arizona, that he incurred the expenses in the course of his work, and that some of the expenses were deductible.
However, the IRS said the term “fee-based” meant “paid fees by a member of the public for a service rendered by a public official (in this case the taxpayer, a judge) who receives the fee.” Because the fees actually went to the county, even though the taxpayer received some benefit from them, he did not qualify for the fee-based public official exception.
The taxpayer says “fee-based” means “a position funded in whole or in part by fees paid by members of the public for services rendered by a public official.” He argues he is a fee-basis official for two reasons. First, the court automatically remits a portion of the fees paid by the public not just to its general fund but directly to the retirement plan. Second, the taxpayer is allowed to collect fees for performing wedding ceremonies.
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For the IRS.
Business expenses are usually thought deductible because they are an ordinary and necessary requirement for producing income. But the taxpayer’s reading of section 62 would uncouple the deductibility of an expense from the income it produces. Under this premise, once a position was funded in part by fees, any employee holding that position would be entitled to unlimited deduction of unreimbursed business expenses regardless of whether those expenses had anything to do with those fees.
We think all this makes the IRS’s reading the better one. The IRS reading is consistent with the ordinary public meaning of the term, consistent with the IRS construction of a similar clause in internal revenue code section 1402, and consistent with other federal statutes’ and regulations’ definitions of compensation on a fee basis.
We therefore hold that for the taxpayer to take his deductions above the line he must show that he received fees directly from the public in exchange for services he rendered.
We find he can’t do this. He doesn’t retain fees collected by his court as compensation for his services. His salary is paid from the county’s general fund. That salary may be funded in part by fees, but the fees aren’t paid in exchange for services the taxpayer renders himself and he isn’t paid them directly.
While it’s true a portion of the fees the superior court collects is automatically remitted to the Elected Officials’ Retirement Plan, in which the taxpayer participates, those fees aren’t paid directly to him by the public, and aren’t distributed to him until several years later. We therefore also hold that the taxpayer wasn’t compensated on a fee basis via his retirement plan.
No portion of the taxpayer’s compensation for his role as a public officer was provided on a fee basis. Rather, he was an employee of the state of Arizona and paid a salary for his work. Thus, his expenses are deductible as unreimbursed employee expenses under section 162 and should be reported as miscellaneous itemized deductions subject to a 2% floor.