IRS

Tax Court: Unsubstantiated Per DiemsCan Be Fully Deductible

Shirley Dennis-Escoffier

A divided Tax Court recentlyoverturned a $111 million taxbill from the 1980s for UnitedAirlines by holding that it couldrecharacterize unsubstantiatedper diem travel allowances intofully deductible compensation.This decision could create aloophole for other corporationsif they are allowed to treat itemsas reimbursed employment-relat-ed expenses (thus avoidingincome and payroll tax with-holding) and then later (whilethe corporate returns are stillopen but after the statute of limi-tations period has expired foremployees) recharacterize theexpenses as fully deductiblecompensation. This could resultin the corporation gaining anincome tax deduction for the fullamount of the expense whileallowing the employees to avoidincome and payroll tax on thecompensation.

FACTS IN UNITEDAIRLINES CASE

During the years at issue(1983–87), United Airlinesemployed approximately 12,000flight attendants and 6,150

pilots. Each of the employeeswas assigned to a series offlights that typically originatedand terminated at the home baseof one or more of the employeesassigned to the flight. Most ofthe flights required that theemployees spend one or morenights away from their homebases (overnight trips). The otherflights brought the employeesback to their home bases on theday of departure (day trips).

Following the terms of itscollective bargaining agree-ments, United paid its pilots andflight attendants per diemallowances of $1.50 per hour($1.55 per hour to pilots forsome years) based on the hoursthey were on duty. Thus, themaximum allowance an employ-ee was entitled to receive for one24-hour period was $36 ($37.50for pilots for some years). Theallowances were paid on bothovernight trips and day trips.United neither required norreceived substantiation from theemployees as to their actual useof the allowances. In addition tothe per diem payments, the air-line also provided (either directlyor through reimbursement) lodg-

ing, ground transportationbetween airports and hotels, anduniform laundering.

Through 1986, Uniteddeducted the per diemallowances on its corporateincome tax returns as employeetravel expenses under InternalRevenue Code Section162(a)(2). On its 1987 incometax return, United deducted 80percent of the per diems, reflect-ing the then-applicable IRC Sec-tion 274(n) reduction for mealexpenses. The airline did notwithhold federal income tax onthe allowances and it neitherwithheld nor paid FICA taxesfor the per diem allowances. Theairline did not report the perdiem allowances as compensa-tion on the employees’ W-2forms. Additionally, the airlinereported its payments of the perdiem allowances as travelexpenses for financial account-ing purposes.

On audit, the IRS deter-mined that the day-trip perdiems were not deductiblebecause meals on trips that arenot overnight are not deductibletravel-away-from-home expenses(but instead are nondeductible

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personal expenses of theemployees). For the overnightper diems, the IRS determinedthat the airline could deduct nomore than the $14 then-currentper diem for meals. So it disal-lowed all per diem allowancespaid by United in excess of $14except for 1987, when it disal-lowed the excess paid over$11.20 (80 percent of $14) asonly 80 percent of qualifiedmeal expenses were deductiblein that year. The IRS thenclaimed that these disallowedamounts were subject to employ-ment taxes.

United Airlines responded bypaying the employment taxes andthen filing a claim for refund inthe U.S. Court of Federal Claims(that case is still pending). At thesame time, the airline filed itscase in Tax Court to contest thedisallowance of its income taxdeductions. United conceded thatthe per diems paid for the daytrips were not deductible as travelexpenses but maintained theywere instead deductible as com-pensation. The airline also arguedthat any part of the overnight perdiem that was not deductible as atravel expense should bedeductible as compensation.

RULES ON PER DIEMS

Although Internal RevenueCode Section 162(a) allows adeduction for all the ordinaryand necessary expenses, includ-ing travel expenses, incurred incarrying on a trade or business,Section 274(d) states that nodeduction is allowed for anytravel expenses unless specificsubstantiation requirements aremet. Substantiation usuallymeans keeping receipts or otherrecords to provide the necessarydocumentation or paying a perdiem rate that is not in excess ofthe federal per diem rate.

For the years covered by theUnited Airlines case, the relevantauthorities were Revenue Rul-ings 80-62 and 84-164. RevenueRuling 80-62 provided a maxi-mum per diem deduction of $44per day for travel expenses,including meals, lodging, laun-dry, and tips. However, RevenueRuling 84-164 stated that theprevious ruling did not applywhen the per diem allowanceswere intended to cover onlyemployee meal expenses orwhen there is no lodgingexpense. Thus, under RevenueRuling 84-164, a meals-only perdiem allowance of no more than$14 would qualify as a substanti-ated travel expense.

Under current law, employ-ers can reimburse their employ-ees for business travel expensesunder either an accountable or anon-accountable plan. To qualifyunder an accountable plan, thepayments must be for deductiblebusiness expenses, the expensesmust be substantiated, and theemployee must return any excesspayments to the employer. Tomeet the substantiation require-ment, either (1) the employeemust submit receipts and otherdocumentary evidence to theemployer or (2) the plan mustuse a per diem rate that is not inexcess of the federal rate.

If an employer maintains anaccountable plan, reimburse-ments or per diems are not con-sidered compensation and notreported on Form W-2. Thus,these payments are exempt fromwithholding, as well as payrolltaxes, saving taxes for both theemployer and employee. If anemployee is reimbursed for trav-el expenses under a plan thatdoes not require the employee toaccount to the employer or ispaid in excess of the federal perdiem rate, it is considered a non-accountable plan and these pay-

ments are treated as compensa-tion income that must be report-ed on Form W-2 and are subjectto withholding and payroll taxes.

For example, assume that anemployer pays an employee a perdiem allowance to cover busi-ness expenses for meals andlodging for travel away fromhome at a rate of 120 percent ofthe federal per diem rate for thelocalities to which the employeetravels. The employee substanti-ates six days of travel away fromhome: two days in a locality inwhich the federal per diem rateis $100 (which the employerreimburses at $120 per day) andfour days in a locality in whichthe federal per diem rate is $125(which the employer reimbursesat $150 per day). The employerreimburses the employee $840for the six days of travel [(2 x120) + (4 x $150)] and does notrequire the employee to returnthe excess payment of $140 [2days x ($120 - $100 federal perdiem rate) + 4 days x ($150 -$125 federal per diem rate)].Under current law, the employermust treat the $140 as taxablecompensation subject to with-holding and payroll taxes.

Additionally, if an employerpays a per diem allowance inlieu of reimbursing actualexpenses for lodging or mealand incidental expenses, anyadditional payment for theseexpenses is treated as paid undera non-accountable plan and mustbe included in the employee’sgross income. For example,assume an employee receives aper diem allowance for lodging,meals, and incidental expenseswhile traveling away from homeand during that trip, the employ-ee pays for dinner for theemployee and two business asso-ciates. If the employer reimburs-es that meal expense for theemployee and the two business

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associates as a business enter-tainment meal expense, theamount paid by the employerfor the employee’s portion ofthe business entertainment mealexpense will be treated as paidunder a non-accountable plan(because the employee hasalready been reimbursedthrough the per diemallowance) and must, undercurrent law, be reported ascompensation subject to with-holding and payroll taxes.

An employer generally musttreat a meal per diem allowanceas a food and beverage expensethat is subject to the 50 percentdeduction limit on meals (andentertainment) under Section274(n). Since 1998, a specialincreased percentage has beenallowable for food and beverageexpenses of individuals whosehours of service are limited bythe Department of Transporta-tion, including air transportationemployees, interstate truckers,and bus drivers, so that 60 per-cent is deductible for 2000 and2001 and 65 percent will bedeductible in 2002. If, however,the payments are consideredcompensation, the percentagelimitations apply instead only todeductions at the employee level,allowing the employer to deduct100 percent of the amount that isconsidered compensation. So ameal expense that is reclassifiedas compensation will be 100 per-cent deductible by the employer(although it may be subject topayroll taxes).

MAJORITY OPINION

In UAL Corp., et al. v. Com-missioner (117 TC No. 2,7/13/2001), United Airlines con-vinced the majority of the TaxCourt justices to allow it torecharacterize as deductiblecompensation the day-trip per

diem travel allowances and theexcess portion (over $14) of theovernight per diem travelallowances. The majority of thecourt concluded that United paidthe per diems for services ren-dered because the allowanceswould not have been paid exceptfor (1) a bona fideemployer/employee relationshipand (2) the need to pay theallowances under collective bar-gaining agreements required tosecure the employees’ services.The court determined thatreporting the per diems as travelexpenses for both tax and finan-cial accounting purposes and theunion contracts’ failure to char-acterize the per diems as com-pensation were not controlling indetermining their character.

Additionally, the courtimplied that IRS was inconsis-tent in arguing that the per diemswere not wages for income taxdeduction purposes while main-taining that they should be treat-ed as wages for employment taxpurposes. Despite the fact that amajority of justices ruled inUnited Airlines’ favor, this wasnot a clear win for the airlinebecause there was a lengthy dis-senting opinion.

DISSENTING OPINION

In a strongly worded dis-senting opinion, three judgessaid that the airline should notbe allowed to claim per diems asdeductible compensation manyyears after it treated them fortax purposes as travel expenses.They pointed out that existingcase law limited a taxpayer’sability to change the treatmentof reported deductions andincome. They feared that themajority’s opinion was a “judi-cially created loophole” for cor-porations by allowing expensesthat would otherwise be disal-

lowed under Section 274(d) tobe recharacterized as deductiblecompensation. Because corpora-tions generally have their statuteof limitations held open longerthan individuals, the opinionwould allow corporations totreat expenses as travel expenseson their tax returns and to avoidincome and employment taxwithholding. Then, after thestatute of limitations expired forthe employees, the corporationcould recharacterize the travelexpenses as compensation. Thecorporation would obtain anincome tax deduction for therecharacterized compensation,but the employees would avoidincome and employment taxeson the compensation.

Additionally, by recharac-terizing the travel expenses asdeductible compensation for1987 and later years, the por-tion of the previously treatedtravel expenses that representedmeal or entertainment expensesno longer needs to comply withthe percentage limitations ofSection 274(n) and becomesfully deductible.

STAY TUNED!

Although this case dealtwith prior law, its conclusioncould aid businesses that want torecharacterize other types ofreimbursed employee expensesas deductible compensation. TheIRS is likely to appeal this deci-sion in light of the strong dis-senting opinion and the fact thata significant amount of tax dol-lars are involved. So corpora-tions considering such recharac-terization of expenses shouldcarefully watch the anticipatedappeal of this case, along withthe related employment tax case,before relying on it as authority.If upheld on appeal, this couldprovide a corporate opportunity.

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Shirley Dennis-Escoffier, Ph.D., CPA, is an associate professor of accounting at the University of Miamiat Coral Gables, Florida. She previously worked in public accounting for several corporations. She is pres-ident of the American Tax Association and has published numerous articles in tax journals.