Hypothetically speaking, what are the odds you have income when your employer pays for your tax return preparation?
In Office of Chief Counsel Memorandum 201810007, the question was whether employer-provided tax preparation services for foreign tax returns were included in the employees’ gross income.
The taxpayer, an American company that employed US citizens or residents in countries around the world, maintained a policy to “equalize” the tax burden of employees. The purpose of the policy was to make sure employees working in a foreign country would pay the same amount of tax they would have paid if they had worked in the US.
Under the policy, the taxpayer calculated a hypothetical tax at the beginning of the year and paid all the taxes (US and foreign) for the employee. These payments were income to the employee and were taxable. At year-end, the taxpayer compared the hypothetical amount to the actual tax and settled the difference with the employee.
The taxpayer paid a multinational accounting and consulting firm to prepare employees’ tax returns. The outside firm was also paid to calculate the hypothetical and actual tax for employees, and to perform other related services for the taxpayer. The taxpayer included the value of the preparation of US and state tax returns as income and wages to employees and did not include the value of foreign tax return preparation.
In making the determination of what portion of the services to exclude from employee wages, the taxpayer reasoned that the employees would not have had to pay for foreign tax preparation had they not been employed out of the country, and that any additional benefit employees received from the services of the accounting firm were primarily provided for the taxpayer’s benefit and not the employees’ benefit and were therefore nontaxable to the employee. (See Field Service Advice 200137039, in which the IRS concluded that the value of services provided to the employer for the specific purpose of calculating the amount owing by, or due to, the employer to equalize the income tax costs of its employees working in other countries is excludable as a working condition fringe benefit under section 132(d).)
The IRS said the taxpayer understated the amount that should have been included in employee wages.
Here is a list of services provided related to the taxpayer’s equalization policy. Which do you think the IRS included in the gross income of the taxpayer’s employees?
1. Calculation of the hypothetical tax
2. Discussions with individuals about equalization issues, travel calendar, etc.
3. Tax payment coordination with the taxpayer for company balances due as part of the equalization arrangement
4. Global coordination of the assignment program (meetings between the taxpayer and the accounting firm, status updates, reporting technology maintenance, etc.)
5. Preparation of basic domestic US tax returns – 1040, 1040 NR, and first state return
6. Sourcing of compensation for federal income tax purposes and the employees’ foreign tax credit
7. Sourcing of compensation for nonresident and part-year resident state income tax purposes
8. Preparation of Form 1116 (Foreign Tax Credit) and Form 255 (Foreign Earned Income)
9. Optimization of foreign earned income exclusion or foreign tax credit position
10. Coordination with foreign tax return preparer to confirm globally consistent approach to residency positions, treaty articles, etc.
11. Notification to employees of foreign bank account reporting (FBAR) obligations if they had overseas financial accounts related to foreign assignment
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The enactment of section 132, as part of the Deficit Reduction Act of 1984, resulted in the substitution of a statutory approach for the prior common law approach in determining whether employer-provided fringe benefits are excluded from gross income. The prior common law approach generally looked to whether the fringe benefit was compensatory or non-compensatory.
Consequently, effective January 1, 1985, any fringe benefit is includable in the recipient’s gross income unless the fringe benefit is excluded from gross income by a specific statutory provision.
The value of the tax preparation services provided by the taxpayer was a direct and personal benefit to the assignees. Therefore, such value is includable in income unless excluded by a specific statutory provision, such as section 132(d) which excludes working condition fringes.
In order for a benefit to be excludable as a working condition fringe, the expense incurred in providing the benefit must be an expense that the employee could deduct under section 162 if the employee had paid for the benefit herself or himself.
The tax preparation services in this case are not deductible by the employee under section 162 because they are different from the business expenses of preparing a Schedule C (Profit or Loss From Business), or resolving asserted tax deficiencies relating to a taxpayer’s sole proprietorship.
Like the expenses associated with preparing a federal income tax return, including Form 1040, Schedule A (Itemized Deductions) and Schedule B (Interest and Dividend Income), the tax preparation services provided by the taxpayer to the assignees are personal expenses of the assignees that would only be deductible by the assignees, if at all, under section 212.
In order for a fringe benefit to be excludable under section 132(d), as a working condition fringe, the employer must derive a substantial business benefit from the provision of the property or services that is distinct from the benefit that it would derive from the mere payment of additional compensation, and the employee’s hypothetical payment for the property or services would otherwise be allowable as a deduction by the employee under section 162. An amount that would be deductible by the employee under a section other than section 162, such as section 212, is not a working condition fringe.
The value of tax preparation services provided in this case cannot be deductible under section 162 because section 212 explicitly provides that all the ordinary and necessary expenses paid or incurred during the taxable year in connection with the determination, collection, or refund of any tax are deductible under that section (and thus not under section 162).
The value of the employer-provided tax preparation services in this case cannot possibly qualify as a working condition fringe benefit under section 132(d) because the cost of such services is not allowable as a deduction by the employees under section 162.
Consequently, the value of employer-provided tax preparation services in the present case cannot be excluded from the assignees’ gross income under section 132(d) as a working condition fringe benefit.
Similarly, as regards the foreign tax preparation services, since the assignees received the same or similar personal benefit from having their foreign tax returns prepared as they did from having their domestic returns prepared and were personally obligated to file complete and accurate tax returns, there is no valid basis for excluding the value of the foreign tax preparation services from gross income while including the value of the domestic tax preparation services. Expenses paid or incurred by a taxpayer in connection with the determination, collection, or refund of a foreign tax are deductible under section 212 in the same manner as expenses paid or incurred in connection with the determination, collection, or refund of a domestic tax.
The receipt of the taxpayer-provided tax preparation services (both for the domestic and foreign returns) conferred a direct and personal benefit on the assignees, and the value received must be included in the assignees’ gross income under section 61.
In summary, the assignees in this case were obligated to file tax returns (both domestic and foreign), and the tax preparation services provided to them by the taxpayer had a direct bearing on their ability to fulfill this personal obligation. An employer paying a personal expense of an employee results in taxable income to the employee.
Accordingly, based on the foregoing, the value of the tax preparation services is includable in the assignees’ income.
The IRS correctly did not assert that the costs attributable to the taxpayer’s equalization computations were includible in the assignees’ income and wages. These expenses are correctly viewed as expenses of the employer and, unlike tax return preparation costs, are not personal expenses of the assignee.