Working-Condition Fringe Benefits
Eighth Circuit Ruling Allows Exclusion of Employer-Paid Fishing Trips

By Steven C. Colburn

E-mail Story Print Story

Fringe Benefits in General

IRC section 61(a)(1) provides that gross income includes compensation for services, including fringe benefits. Under Treasury Regulations section 1.132-6(c), the value of any fringe benefit that would not be unreasonable or administratively impractical to account for is includable in an employee’s gross income, unless that benefit is excluded as a de minimis fringe benefit. Treasury Regulations section 1.61-21(a)(2), however, states that if a specific IRC section provides for the exclusion of a particular fringe benefit from gross income, that section governs the tax treatment of that fringe benefit.

Although neither the IRC nor Treasury Regulations define the term “fringe benefits,” section 132(a) provides that gross income does not include the following:

• No-additional-cost services: any service provided by an employer to an employee for use by the employee if—
  • n the service is offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services, and
  • the employer incurs no substantial additional cost (including forgone revenue) in providing the service to the employee [IRC section 132(b)].
• Qualified employee discounts: a discount for employees on property or services offered for sale to the general public in the line of business in which the employee works. Limitations apply as set forth in section 132(c).
• Working-condition fringes.
• De minimis fringes: property or services provided to employees of such a small value as to make accounting for it impractical [section 132(e)].
• Qualified transportation fringes. Examples include commuting in an employer-provided vehicle, transit passes, and free parking [section 132(f)]. Limitations apply.
• Qualified moving expense reimbursements: any amount received (directly or indirectly) by an individual from an employer as a payment for or a reimbursement of expenses which would be deductible as moving expenses under section 217 if directly paid or incurred by the individual [section 132(g)].

Treasury Regulations provide examples of fringe benefits such as:

• An employer-provided automobile;
• Free employer-provided tickets to sporting or entertainment events; and
• Free travel on an airplane provided by an employer.

In addition, excludable fringe benefits include qualified tuition reductions provided to an employee [IRC section 117(d)] and meals and lodging furnished to an employee for the convenience of the employer [section 119(a)]. No-additional-cost services, qualified employee discounts, de minimis fringes, and working-condition fringe benefits are not excludable under IRC section 132(l) if another IRC section specifically provides the tax treatment of the benefit.

Working-Condition Fringes

IRC section 132(d) defines working-condition fringe benefits as any property or services provided to an employee if such payment would be allowable as a deduction for the employee under IRC section 162(a) (for ordinary and necessary trade or business expenses) or 167 (for depreciation expense). An ordinary expense is one that is customary or usual within the experience of a particular trade, industry, or community. An amount that would be deductible by an employee under another section, such as section 212 (expenses for production of income), is not a working-condition fringe benefit [IRS Regulations section 1.132-5(a)(1)(iii)].

For purposes of the working-condition fringe exclusion, Treasury Regulations section 1.132-1(b)(2) defines an employee as—

• any individual who is currently employed by the employer;
• any partner who performs services for the partnership;
• any director of the employer (except where the working-condition fringe benefit consists of the use of consumer products primarily for testing purposes); or
• any independent contractor who performs services for the employer (except where the working-condition fringe benefit consists of parking or the use of consumer products primarily for testing purposes).

IRS Letter Ruling 199929043 established that benefits provided to an employee’s family members or dependents may not be excluded from an employee’s income as working-condition fringe benefits.

Examples of common working-condition fringe benefits include—

• employer-paid subscriptions to business periodicals for employees;
• employer expenditures for on-the-job training or business travel for employees;
• use of employer-provided vehicles for business purposes; and
• educational assistance that is not provided under a qualified educational assistance program (and thus not excludable under IRC section 127).

Cash paid to an employee may also qualify as a working-condition fringe benefit if the following requirements are met [IRS Regulations section 1.132-5(a)(1)(v)]:

• The payment is required to be used in a specific or prearranged activity for which a deduction is allowable under IRC section 162 or 167;
• The employee verifies that the payment is actually used for such expense; and
• The employee returns to the employer any part of the payment not used for the specified purpose.

IRS Letter Ruling 9822044 established that the third requirement does not apply to a reimbursement arrangement in which only substantiated expenses are reimbursed. Under such a plan, there would be no payments to return.

Townsend Decision

Townsend Industries, based in Iowa, manufactures a product that allows offset printers to produce two-color documents in a single pass through a printing press. For over 40 years, Townsend has held a two-day annual meeting (on a Monday and Tuesday) at its corporate headquarters for its salespeople, its corporate staff, and some factory workers. Subsequent to the meeting, the company sponsored a four-day expenses-paid fishing trip for the salespeople and employees to an Ontario, Canada, resort. Wednesday and Saturday were travel days, and Thursday and Friday were fishing days. The trip was not mandatory, but all employees were encouraged to participate and over half did on a regular basis. Wives and children of employees and salespeople were not invited on the trips.

Townsend deducted the cost of the fishing trips as a working-condition fringe benefit. The IRS determined that the per-employee cost of Townsend’s annual fishing trip was wages, and assessed deficiencies against the company for tax years 1996 and 1997. Townsend paid a portion of the deficiency and filed suit, seeking a refund.

Employees testified that, although fun, the trip was more than a vacation. They viewed it as part of their jobs and were paid their regular wages during the trip. Except for a dinner at which the company president and the CEO spoke about the state of the company, the employees’ and salespeople’s time was their own. The vast majority of them fished, but they also conducted business discussions on a regular basis during the trip. The sales personnel and employees stated that they discussed business from one to four hours per day and that such discussions occurred on the bus trips to and from the resort, during meals, on boats, and in cabins. Many topics discussed at the sales meeting on Monday and Tuesday were also discussed on the fishing trip. To encourage these discussions, the president and the CEO assigned specific individuals to share cabins and fishing boats. These assignments were flexible, however, and could be changed for any reason. Employees testified that they felt they gained an advantage in performing their jobs and solved specific problems by attending the fishing trips, although they were apparently vague in their testimony as to what the business discussions entailed and in which year the discussions occurred.

The U.S. District Court for the Southern District of Iowa found for the IRS, holding that the expenses for these trips were employee wages. It ruled that a portion of these wages should have been withheld for income tax and Social Security and Medicare taxes. Townsend appealed to the Eighth Circuit.

The district court (92 AFTR 2d 2003-6096, 342 F3d 890) noted that although the terms “ordinary and necessary” have been repeatedly construed and applied, no definite standard can be formulated for determining whether a claimed deduction can qualify as an expense that is ordinary and necessary in the particular taxpayer’s business [Wells-Lee v. Comm’r, 360 F.2d 665, 668-69; 17 AFTR 2d 964 (8th Cir. 1966); citing Welch v. Helvering, 290 U.S. 111; 12 AFTR 1456 (1933)]. In Wells-Lee, citing Byers [199 F.2d 273; 18 AFTR 2d 1252 (8th Cir. 1964)], the court stated that “in general, a business expense is tested by its normalcy and soundness considered in light of the nature of the taxpayer’s trade or business, but the determination of whether an expense is ordinary and necessary and the taxpayer’s purpose in making a particular payment are usually questions of fact.”

In determining whether the fishing trips were ordinary and necessary expenses for Townsend, the court observed that the majority of Townsend employees did not participate in the Monday and Tuesday sales meetings, their roles generally being limited to introductions and brief conversations with salespeople before those meetings began. While all employees were invited and encouraged to attend the fishing trips, some employees did not attend the trips, and others went every year. Although business was certainly discussed during the trips, the discussions were not held in an organized and monitored fashion to ensure that items discussed at the sales meetings were pursued.

Townsend conceded that its fishing trips might not be ordinary, but asserted they were in keeping with its business philosophy. It stated that it encouraged employees to choose to be part of the company team and not to feel obligated to do certain things.

To support its position, Townsend cited Poletti (330 F.2d 818; 13 AFTR 2d 1252; 8th Cir., 1964), in which an employment agency was allowed to deduct, as IRC section 162 ordinary and necessary expenses, gifts made to individuals who sought placement with the agency and to companies where it placed employees. The Eighth Circuit described such gifts as “really nothing more than a form of promotional advertising to advance its business,” adding that the company should not be “penalized tax-wise for business ingenuity in utilizing advertising techniques which do not conform to the practices of one whom he is naturally trying to surpass in profits.” The district court stated that the current case was distinguishable from Poletti, and that it could find no case law supporting Townsend’s claim that a voluntary, company-wide, all-expenses-paid, employer-sponsored fishing trip with one brief business meeting was an ordinary and necessary business expense.

Directly-related-to and associated-with tests. The court stated that even if Townsend’s fishing trips qualified as ordinary and necessary business expenses under IRC section 162, it must still prove, under section 274(a)(1)(A), that the expenses, as entertainment, were directly related to or associated with the active conduct of its business, to be able to deduct them.

Directly related. Per Treasury Regulations section 1.274-2(c)(3)(i)–(iv), the taxpayer must meet all four of the following tests for the expenses to be considered directly related:

• At the time the taxpayer made the entertainment expenditure (or committed himself to make the expenditure), the taxpayer had more than a general expectation of deriving some income or other specific trade or business benefit (other than the goodwill of the person or persons entertained) at some indefinite future time.
• During the entertainment period, the taxpayer engaged actively in a meeting, negotiation, discussion, or other bona fide business transaction (other than entertainment) for the purpose of obtaining such income or trade or business benefit. If, after incurring the expenditure or committing himself to it, the taxpayer cannot engage in the discussion because of reasons beyond his control, this test would be considered met.
• In light of all the facts and circumstances, the principal character or aspect of the combined business and entertainment to which the expenditure related was the active conduct of the taxpayer’s trade or business. (Or, at the time the taxpayer made the expenditure or committed himself to the expenditure, it was reasonable for the taxpayer to expect that the active conduct of trade or business would have been the principal character or aspect of the entertainment, even if such was not the case solely for reasons beyond the taxpayer’s control.) It is not necessary that more time be devoted to business than to entertainment to meet this requirement. However, the active conduct of a trade or business is not considered to be the principal character or aspect of combined business and entertainment activity on hunting or fishing trips, or on yachts or other pleasure boats, unless the taxpayer clearly establishes to the contrary.
• The expenditure was allocable to the taxpayer and a person or persons with whom the taxpayer engaged in the active conduct of trade or business during the entertainment.

Associated with. Per Treasury Regulations section 1.274-2(d)(1)–(2), for an entertainment or recreational activity to be associated with the active conduct of a trade or business, it must directly precede or follow a substantial and bona fide business discussion. The expenditure must have a clear business purpose, such as to obtain new business or to encourage the continuation of an existing business relationship. IRS Revenue Ruling 63-144 states that business goodwill entertainment, including hunting or fishing trips, can qualify under the “associated with” test if the taxpayer can show that the entertainment took place directly before or after a substantial and bona fide business discussion. While it is not necessary that more time be devoted to business than to entertainment, the taxpayer must actively engage in a business meeting, negotiation, or discussion that is substantial in relation to the entertainment.

For example, in Auto Zapper & Towing, Inc. (TC Memo 1992-662), a taxpayer in the business of repossessing cars, boats, and motor homes for financial institutions paid for a weekend trip to Las Vegas. Although the taxpayer’s business increased significantly as a result of the trip, he could not deduct the expenses for the trip, because it did not satisfy the “associated with” test. The taxpayer did not actually conduct business or any substantial business discussions immediately before or after the entertainment.

Townsend also cited as support the ruling in People’s Life Insurance Company (373 F.2d 924; 19 AFTR 2d 979; Ct. Cl. 1967), in which an insurance company was not required to treat as wages expenses paid to send certain employees and their wives to a convention where the employees were expected to attend planned business meetings and had very little free time. The district court rejected Townsend’s claim, noting that People’s held actual business meetings, and “the business meeting status of the event was not destroyed because pleasurable pursuits were included.” It distinguished Townsend’s situation from that in People’s: The fact that only one brief business meeting was held on Townsend’s fishing trips was a major factor in finding that the trips were not ordinary and necessary business expenses.

Substantiation requirements. For a taxpayer to be able to deduct entertainment or recreation expenses as qualifying ordinary and necessary business expenses, the taxpayer must adequately substantiate the expenses pursuant to IRC section 274(d)(1)–(2). Adequate records must document the following:

• Amount of the expense;
• Time and place of the travel, entertainment, amusement, recreation, or use of the facility or property;
• Business purpose of the expense; and
• Business relationship of the persons entertained to the taxpayer.

The court cited Townsend’s lack of documentation of its fishing trip expenses as further reason to deny its case.

The district court concluded that Townsend’s fishing trip expenses did not qualify as ordinary and necessary business expenses under IRC section 162(a) and therefore could not qualify as working-condition fringe benefits under IRC section 132(a)(3). It ruled that Townsend did not demonstrate that the main character of what it termed “basically fun fishing endeavors” was the active conduct of Townsend’s business under IRC section 274(a). According to the court, Townsend’s expectation that the trips would improve future employee morale and camaraderie was not sufficient to meet the business-purpose test. The time lag between the sales meetings and the fishing trips was too great for the trips to meet the “associated with” test of IRC section 274. Finally, even if the fishing trip expenses qualified under sections 162 and 132, Townsend did not provide the documentation required under the strict provisions of IRC section 274(d).

The Eighth Circuit

The Eighth Circuit disagreed with the district court’s holding that Townsend failed to establish a business purpose for the fishing trips. On the contrary, it concluded that testimony by both Townsend and the IRS clearly established that the trips were business trips. It noted that most of the employees that testified felt an obligation to go on the trips and that some felt the trips were a part of their jobs, even if they were not mandatory. The court noted that both the owner, Robert Townsend, and the CEO, John Jorgensen, strongly encouraged all employees to go on the trips. The chief engineer, Dean Evans, added that he did not look forward to the annual fishing trip, but felt a responsibility to attend, stating, “The fishing trip is where we launch products, introduce it to our staff, and so it’s a pretty tough time.”

The court cited additional evidence that the trips were reasonable and necessary business trips and that business was conducted on the trips. Witnesses testified that discussions during the 1996 trip focused on the need to introduce a new press to compete with one produced by a competitor. During the 1997 trip, Townsend introduced its new model. An independent distributor testified that there would have been a lot of discussion during the 1996 trip about the new press. He stated that the new model was unveiled at the 1997 sales meeting and that necessary follow-up discussions took place during the 1997 fishing trip. Further discussions centered on another press and on problems experienced by customers, employees, and salespeople.

Witnesses testified that the annual fishing trips provided unique opportunities for the national salespeople to interact with the Townsend employees who manufacture, assemble, and maintain the company’s intricate products. Salespeople were able to impress on the factory workers the need for attention to detail. One salesperson stated that he told a Townsend employee about the 600-mile round-trip service call he had to make because too many burrs were left on the gears of a press. Discussions between salespeople and parts-distribution employees also resulted in improvements in the distribution of parts, such as new parts codes and increased accuracy in the parts sent. One employee testified that Townsend was so busy and hectic that the fishing trip provided a rare opportunity to have a reasoned conversation with his supervisor about their work. Factory employees and salespeople generally agreed that they returned from the trips with a better understanding of Townsend’s business and how to correct certain problems.

The fact that in 1994 Townsend stopped including the employees of its plastics division on the annual fishing trips was viewed by the court as strong evidence that these trips had a bona fide business purpose. Townsend testified that it sold the plastics division in 1997 because the division was no longer making only the plastics parts that Townsend had bought it to make. Townsend thought that its presence at the sales meetings and the fishing trips was becoming disruptive. The court viewed this action as strong evidence that Townsend had a clear business purpose for the fishing trips and was not just providing a free vacation to its employees.

The Eighth Circuit also disagreed with the district court’s conclusion that Townsend merely had a general expectation to derive uncertain future benefits, particularly in the way of camaraderie and relations among its employees and sales personnel. It cited discussions between employees and sales personnel regarding sales tactics, quality control, specific clients, and other problems solved or discussed, as evidence of specific problems discussed on the trips. The court decided that these discussions resulted in specific business benefits to Townsend that went far beyond improvements in employee relations or morale. It concluded that, based on its knowledge of past experience, Townsend realistically expected to gain concrete future benefits from the trips. The court ruled that the trips and their expenses qualified as working-condition fringe benefits under IRC section 132(a) and as bona fide business expenses under IRC sections 162(a) and 274(a). The testimony at trial provided by Townsend and the IRS provided adequate substantiation under section 274(d) to prove the business nature of the expense.

The IRS’s Position

The IRS viewed Danville Plywood Corporation [889 F.2d 3 (Fed. Cir. 1990)], concerning the deductibility of a corporate trip to the Super Bowl, as controlling in Townsend. In Danville, the Federal Circuit held against the taxpayer, noting that very little business discussion occurred and that spouses and children also attended the trip. The court concluded that the trip was primarily a group social event, with business playing a subsidiary role. The Eighth Circuit distinguished the Townsend trip from that in Danville, stating that there was evidence that specific business discussions were held and that business benefits were derived on the Townsend trips. Significantly, the absence of spouses and children on the Townsend trips underscored the business, rather than vacation, nature of those trips.

The Eighth Circuit also rejected Hippodrome Oldsmobile, Inc. [474 F.2d 959 (6th Cir. 1973)] as not relevant. This company entertained customers on a boat, then attempted to deduct depreciation and maintenance expenses for the boat. The Sixth Circuit held that the taxpayer did not demonstrate a business purpose for the boat trips because customers were not specifically exposed to the taxpayer’s products. The court viewed the boat entertainment as having no specific business purpose other than to generate goodwill. In contrast, Townsend employees and salespeople were exposed to and discussed Townsend products. Furthermore, new Townsend products were initiated and subsequently introduced during the trips. Also, customer complaints, product defects, and other business practices were discussed at length during Townsend’s fishing trips. The Eighth Circuit concluded that Townsend was trying to accomplish much more on its trips than just generate goodwill.

Click here to see a Sidebar.

Editor’s Note: The Townsend case and the deductibility of fringe benefits were also the subject of “Are Business Trips Deductible Expenses or Taxable Employee Fringe Benefits?,” by Clyde L. Posey and Xing Xie, in the March 2005 CPA Journal.