Are Business Trips Deductible Expenses or Taxable Employee Fringe Benefits?

By Clyde L. Posey and Xing Xie

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The Facts of the Case

Townsend, an Iowa corporation located in Altoona, Iowa, manufactures printing press attachments that are used to print multiple-color documents in small printshops. Robert Townsend has been the sole shareholder since he founded the company in 1957. The company distributes its products using three in-house sales personnel, two independent corporations, and international salespersons.

Each year since the company was established, Townsend has arranged a June sales meeting followed by a fishing trip. Generally, the in-house sales personnel and some of the other salespersons come to the Altoona office for the sales meeting on a Monday and a Tuesday. Some other company employees also attend the sales meeting, and a variety of topics are discussed.

After the sales meeting, Townsend employees, the sales personnel, and company executives are invited to Canada for a business fishing trip. On Wednesday, employees take a 12-hour bus ride to the resort. Much of Thursday and Friday is spent fishing, with business discussions occurring before and afterward. All Townsend employees return home on Saturday morning.

Townsend, Inc., pays for the fishing trip. Employees are strongly encouraged to attend (although it is not mandatory), and receive their regular compensation while on the trip. Employees that do not attend the trip must work at the Altoona office. Families of employees and sales personnel are not invited. Employees generally considered the annual trips as an important part of their job: the September 15, 2003, appellate court record states, “In short, the record leaves us with little doubt but that the Townsend employees viewed the annual trip as part of their regular course of business.”

In 1996 and 1997, as in previous years, after two days of sales meeting in the company’s office in Altoona, employees and other salespersons went to Canada for the fishing trip. The court record showed that business discussions occurred on the way to the destination and in the cabins. Cabin arrangements and boat arrangements were made by Townsend and the CEO, John Jorgensen, to encourage business discussions between employees and salespersons. On the Friday night of both years, as previously, Townsend and Jorgensen gave speeches that addressed the current and future business of the company.

Because the company viewed the cost of annual fishing trip as an ordinary business expense, it deducted the expenses from gross income. After examining the company’s 1996 and 1997 tax returns, the IRS initially determined that fishing trip expenses paid by the employer could not be excluded as IRC section 132 working condition fringe benefits; furthermore, Townsend, Inc., did not provide sufficient documentation to meet IRC section 274(d) substantiation requirements. Therefore, the IRS asserted that the fishing trip expenses should be included in employees’ taxable wages, and assessed deficiencies for employment tax. After the company paid a portion of the deficiencies on June 16, 2000, it filed a suit seeking a refund. The IRS filed a counterclaim for the remaining tax deficiencies.

‘Ordinary and Necessary’

Although the phrase “ordinary and necessary” is not specifically defined, Treasury Regulations section 1.162-2 defines it obliquely with examples. In Deputy v. du Pont, the Supreme Court defined ordinary as “normal, usual, or customary.” The general definition of necessary has been “appropriate and helpful in the taxpayer’s business.” In effect, the definition of “ordinary and necessary” is based on the facts and circumstances of each situation.

This ambiguity has led to significant differences of opinion between taxpayers and the government. Treasury Regulations section 1.162-2 states: “Only such traveling expenses as are reasonable and necessary in the taxpayer’s business and directly attributable to it may be deducted.”

Townsend, Inc., contended that the sales meeting and the following fishing trip had helped the company prosper. The company argued that the fishing trip expenses qualified as “ordinary and necessary expenses.” The district court, however, held that whether the deductions were allowable depended on the answers to two questions:

• Was the fishing trip mandated by management?
• Was the fishing trip a continuation of the Monday and Tuesday sales meetings?

Townsend employees were asked to indicate whether they planned to attend by signing a sign-up sheet months in advance of the trip. Townsend and other senior management testified that they strongly encouraged every employee to attend, but did not make the trips mandatory. Townsend testified that “he felt it would be antithetical to his business philosophy to make the trips mandatory,” but most employees viewed the fishing trip as a part of their job. In the final analysis, the district court concluded that the fishing trip, with no strict attendance policy, could not be excluded as a working condition fringe benefit.

The district court found that on the Friday night of the trips, Townsend and Jorgensen gave speeches that addressed the current and future state of the company. The testimony indicated that business discussions occurred during the fishing trip. The court argued, however, that these discussions were not done in “an organized and monitored environment.” “The fact that only a brief business meeting was held on the fishing trip” did not convince the court that the fishing trip was a continuation of the sales meeting.

Although under IRC section 162 all ordinary and necessary business expenses are deductible, the IRS asserted that even if Townsend, Inc., could show that the fishing trip expenses were ordinary and necessary business travel expenses, the deduction would not be allowable, because any deduction for entertainment is limited by IRC section 274. On August 21, 2002, because Townsend, Inc., did not provide adequate evidence to meet the requirements of section 274 in the trial, the district court ruled for the IRS. According to the U.S. District Court:

The government asserts that even if Townsend could show the fishing trips were ordinary and necessary business travel expenses, it cannot meet the heightened requirements of 26 U.S.C. section 274. It alleges section 274 does apply in this case as Townsend cannot show that the fishing trip falls into the category of “recreational expenses for employees” contemplated by section 274(e).

Section 274(e) provides for exceptions from this statute’s heightened requirements. Specifically, subsection 274(e)(4) states that “[e]xpenses for recreational, social, or similar activities (including facilities therefore) primarily for the benefit of employees (other than employees who are highly compensated employees within the meaning of section 414(q))” are not subject to the heightened requirements. This subsection does not exempt Townsend from the application of section 274. As this Court finds that there is a material issue of fact whether the cost of the fishing trips was a ordinary and necessary business travel expense pursuant to section 162, then subsection 274(e)(4) cannot exempt Townsend from section 274’s heightened requirements because, under the code, the trip cannot be both primarily a business travel expense and an expense “primarily for the benefit of employees.” If it was not a business expense under section 162, then the issue of whether section 274’s heightened requirements applies will be a moot question that will not be reached in the analysis of these claims. Thus, subsection 274(e)(4) does not exempt Townsend from the general application of the heightened requirements of section 274.

General Versus Realistic Expectations

At the trial, Townsend and Jorgensen stated that they expected to improve comradeship and relations among employees and salespersons through the fishing trips. The district court concluded that although the fishing trip was not purely to promote good will, the company held only general expectations of deriving uncertain benefits from the fishing trip. Consequently, “such an expectation is not enough to allow the trips to qualify as directly related under Section 274.”

The Court of Appeals, however, concluded as follows:

We need not rehash the extensive trial testimony relating to sales tactics … for the trial record that we have reviewed is replete with evidence of specific and general business benefits that Townsend realized from the trips. Contrary to the District Court’s conclusion that Townsend merely had a general “expectation to derive uncertain future benefits, particularly in the way of improved comradery [sic] and relations among its employees and sales personnel,” … [W]e conclude that Townsend had a realistic expectation to gain concrete future benefits from the trip based on its knowledge of its own small company, its knowledge of the utility of interpersonal interactions that probably would not occur but for the trip, and its knowledge of its own past experience. As such, the trips and their expenses qualified as working condition fringe benefits under [section] 132 and a bona fide business expense under [sections] 162 and 274 of the [IRC]. Necessarily, we also conclude that the trial record developed by Townsend and the Government provided adequate substantiation in the form of its “own statement[s] … containing specific information in detail [and] [b]y other corroborative evidence sufficient to establish” the business nature of the expense.

Many witnesses viewed the fishing trip as a unique opportunity for salespersons to interact with Townsend’s employees. One stated “this interaction was very important because small changes in the attention that the factory workers paid to their work had a major impact on the amount of repair work the sales force had to do and decreased the number and frequency of repairs.” An independent distributor also testified, “Townsend intended to show it (the Anniversary Edition press) to us at the sales meeting. We would then have any discussions that we needed to on the fishing trip as a carryover.” It means that Townsend would reasonably expect that, based on its past experience, discussion at the sales meeting would be continued at the fishing trip, and some benefits would be derived from the discussion.

Furthermore, specific benefits resulted from the 1996 and 1997 fishing trips. For example, after the discussion on the need to introduce a new model during the 1996 trip, a new press was introduced in 1997.

After reviewing the record, the Court of Appeals concluded that Townsend held realistic expectations about the fishing trips.

The ‘Associated with’ Test of Section 274

The “associated with” test is used when the activity is not directly related to the active conduct of the taxpayer’s trade or business. Generally, the test requires that business discussions immediately precede or follow entertainment expenses. If the entertainment and the business discussion do not occur on the same day, the facts and circumstances of each case are to be considered. The district court found that the sales meeting on Monday and Tuesday was too far distanced from the fishing trip that occurred in the following days. Moreover, the district court emphasized that the business discussion occurring on the fishing trip was not conducted in “an organized and monitored environment.” It concluded that the “associated with” test was not met.

On the other hand, most witnesses testified that Townsend-related business was conducted during the 1996 and 1997 fishing trips, and company records showed that employees spent from one to three hours per day discussing Townsend-related business. The Court of Appeals also found that very specific discussions occurred during both trips. For example, many discussions among the employees and salespeople during the 1996 trip focused on the need for a new model to compete with a competitor’s product.

Substantiation Requirements

IRC section 274(d)(4) states that no deduction shall be allowed for travel away from home “unless the taxpayer substantiate[s] by adequate records or by sufficient evidence corroborating the taxpayer’s own statement” the elements of the expenditure, including the amount of, the time and place of, and the business purpose of entertainment expenses, as well as the business relationship to the taxpayer of the persons entertained. According to Treasury Regulations section 1.274-5T(c), “adequate records” comprise an account book, diary, log, statement of expense, trip sheets, or similar documentary evidence. If a taxpayer fails to present the adequate records, the taxpayer must establish the elements of an expenditure “by his own statement, whether written or oral, containing specific information in detail as to such element and by other corroborative evidence sufficient to establish such element.”

The district court held that Townsend failed to provide adequate records to substantiate the business purpose of the fishing trip expense, and that “the testimony about the business purposes of the trip lacked the necessary specificity.”

The Court of Appeals concluded, after reviewing all testimony, that Townsend employees viewed the annual trip as part of their regular course of business. Other notable evidence buttressing the conclusion of business purpose is that Townsend, Inc., stopped including its plastics division in 1994, when it decided to sell the division (which eventually was sold in 1997). “To get the best business and the best results,” as testified in the trial court, the company excluded the plastics division from the 1996 and 1997 fishing trips; this decision indicated that the company has a specific business purpose for the trips. That wives and children were not invited to the trips also supported that conclusion.

Therefore, against the district court’s conclusion, the Court of Appeals concluded that “the trial record developed by Townsend and the Government provided adequate substantiation in the form of its own statements, containing specific information in detail and by other corroborative evidence sufficient to establish the business nature of the expense.” After reviewing the entire trial record, the Court of Appeals concluded that “the trips and their expenses qualified as working condition fringe benefits under Section 132 and a bona fide business expense under Section 162 and 274 of the Internal Revenue Code.”

Prior Cases and Townsend

In Berkley Machine Works & Foundry Company v. Comm’r (623 F.2d 898), the company used hunting and fishing lodges to entertain employees of its customers on weekend outings because the company believed that its business significantly depended on personal contacts and congenial working relationships with its customers. The court ruled to disallow the deduction of maintenance costs for the lodge. The court acknowledged that certain business-related and general economic benefits were gained from the practice, but it argued that the expense was not directly related to the active conduct of Berkley’s business, based on the finding of “general expectation” held by Berkley at the time of the arrangement. Although witnesses testified that some informal and unscheduled business discussions and meetings occurred in the lodge, these discussions were not adequately substantiated under IRC section 274(d). Like Townsend, Berkley provided adequate records of the place, time, and amount of the contested expenditures; however, Berkley kept no written diary of the trips describing the business purpose and business relationship. Furthermore, the court found the testimony of a small portion of the guests did not qualify as “other corroborative evidence sufficient to establish such element.”

In Danville Plywood Corporation v. the United States (899 F.2d 3), the company sponsored a trip for its employees and customers to New Orleans for the Super Bowl. The court found that that “entertainment was the central focus” of the trip and “business played a subsidiary role.” Company records, including letters sent to customers and memoranda distributed to employees, show no relationship between the trip and company business. Unlike Townsend, only a few witnesses testified that business discussions occurred during the trip. Accordingly, the court concluded that the expense of the trip was neither “related to” nor “associated with” the active conduct of the company’s business. Moreover, the fact that spouses of some customers and employees attended the Super Bowl trip demonstrated that it was not arranged primarily for bona fide business purposes.

In Hippodrome Oldsmobile Inc. v. United States of America (474 F.2d 959), an automobile agency maintained some boats to entertain customers. The court concluded that “no bona fide business transaction, other than entertainment” occurred, and did not allow the deduction. Although the company made many sales using this business tactic, the court argued that actual benefits derived from the entertainment could not substantiate that the taxpayer held specific expectations of deriving benefits from the entertainment.

Extreme Caution and Care

Whenever a fishing trip or similar entertainment activity is used in connection with “ordinary and necessary” business expenses, an IRS agent will generally see a red flag. Even in cases where the taxpayer goes to great length to comply with the law, significant differences of opinion can exist, as evidenced by the different interpretations of the law by the district court and the appellate court in Townsend.

According to Todd A. Walter (The Tax Lawyer, Summer 2003, 56 Tax Law, 941), the issues in Townsend can be summarized by four points. The taxpayer needed to show the following:

• There was a more than general expectation of deriving business benefit from the trip;
• Active business discussions were conducted on the trip;
• The principal character or aspect of the trip was the active conduct of business; and
• The expenditure was allocable to the employees’ conduct of business while on the trip.

To achieve more than a general expectation of deriving some business benefit from the trip, Townsend officers should have had very specific goals that they intended to achieve from the outing. In fact, Townsend believed that it had done exactly that. Upon returning from the fishing trip, employees and managers would draft written summaries and notes detailing discussions that had taken place on the trip. The plant manager would meet with management personnel and supervisors to discuss the ideas that had surfaced during the trip. Considering these factors, Townsend argued, it had met the substantial compliance component of Treasury Regulations section 1.274-5T(c)(2)(v)n66.

To fortify its deduction for the business conference in Canada, Townsend executives could have developed in advance very specific goals, challenges, or other areas of concern to discuss. While written summaries were prepared after the Canadian sessions, advance preparation of specific agenda topics and items might have countered the argument that the meeting offered only a general expectation of benefit.

In addition, while active business discussions were conducted on the trip, much unintended emphasis seemed to be on fishing rather than business, and this muddied the water of the deduction. It is reasonable to believe that if a preponderance of the time was spent on business (along with all of the other provisions of the regulations), the examining IRS agent might have accepted the return as it was filed. The appellate court ascertained that the conference was for the active conduct of business; however, the “aroma” coming from the district court proceedings did not lead to that conclusion. A more forceful presentation of that point at the district court level might have saved Townsend some grief.

Moreover, the overarching stated purpose of the trip should have been the active, ongoing conduct of business. Fishing should have been played down. Despite the fact that the plastics division was not invited and that spouses and children were not permitted to attend, which provided a persuasive argument that the trip was for the active conduct of business, the district court was not convinced. The portion of the case presenting “the active conduct of business” could have been strengthened.

Last, the allocation portion of Treasury Regulations section 1.274-2(c)(3)(iv) and 1.274-2(d)(4) should have been observed strictly. Section 1.274-2(c)(3)(iv) states that “the expenditure was allocable to the taxpayer and a person or persons with whom the taxpayer engaged in the active conduct or trade or business.”

Meeting all of those requirements might have caused Townsend to prevail at the audit. Even if Townsend was unsuccessful at the audit level, those points should have been stressed strongly at the district court level.

Whether Townsend is a strong precedent can be answered best by the final paragraph of the appellate decision:

We pause to note that our decision does not stand for the proposition that in all cases in which a corporation sponsors hunting, fishing, or other trips to “luxury” vacation spots that the sponsoring corporation can avoid including the per-employee cost of the trip in its employees’ wages merely by presenting testimony relating to business allegedly conducted during the sojourn. A district court should be suspicious of oral, non-contemporaneous evidence provided in such cases … and it may well be that in most cases the cost of these trips would amount to income taxable to each employee. This caveat notwithstanding, in the case at bar, we have little trouble concluding that Townsend Industries presented adequate evidence to substantiate its business purpose. Though we have reached this conclusion as a matter of law, even if “business purpose” were to be treated as a question of fact, we are satisfied the nature and quantity of the evidence presented could compel no reasonable conclusion other than that Townsend had a bona fide business purpose for its 1996 and 1997 trips.

Obviously, extreme caution and care should be used in business trips with even a hint of questionability. Townsend prevailed, but only after being defeated in an IRS audit and a district court decision. It was an uphill battle for Townsend, and will probably be the same for other taxpayers in similar situations.