IRS Proposes Paradoxical Changes To Tax Rules For Employer-Provided Cell Phones

June 18, 2009

Cellular phones and other similar telecommunications equipment (such as personal digital assistants (PDAs)) are an increasingly common type of employer-provided fringe benefit. One reason for this trend is that current tax law relating to this practice is quite favorable to the extent that employees use the devices for business purposes.

Under current law, employers may deduct the expense of providing employees with the use of such devices, and employees are generally not taxed on the value of that use, but only to the extent the use is business-related. Conversely, the cost associated with personal use is not deductible by the employer, and the value of such use is taxable to the employee. To establish the amount of business-related use, employers and employees must meet specific substantiation requirements that can be quite difficult to satisfy in practice.

In response to this situation, the Internal Revenue Service (IRS) has proposed three alternative methods for meeting the substantiation requirements and has invited public comment on the proposed new rules. (See IRS Notice 2009-46). Adding to the confusion, the Commissioner of the IRS has recently announced that the Obama administration is asking Congress to change the current tax laws to eliminate any tax consequences to employers or employees for personal use of work-related cellular phones and PDAs.

Both of these developments are described in greater detail below.

Current Law

A detailed set of rules governs the tax treatment of employer-provided cellular phones and PDAs (both of which are generally referred to in this article as “cell phones”). Under these rules, cell phones are subject to a strict set of requirements regarding the substantiation of their cost and use. Compliance with these requirements is a precondition to obtaining the favorable tax consequences described above.

The substantiation rules apply to “each element of the expenditure or use” relating to the cell phone. The information required to be collected and maintained includes:

  • The amount of each separate expenditure with respect to the cell phone, such as the cost of acquisition.
  • The amount of each business use (measured based on the amount of time it is used), and the amount of total use of the cell phone for the tax year.
  • The date of the expenditure or use of the cell phone.
  • The business purpose for an expenditure or use of the cell phone.

Noncompliance with these rules can result in liability for unpaid taxes, interest and penalties. This can be particularly problematic for executives and board members of many tax-exempt organizations. Even though those organizations generally are not concerned with the loss of tax deductions, certain executives and board members can be assessed tax penalties if amounts that are intended as compensation are not correctly reported. It is particularly important that tax-exempt organizations maintain cell phone use policies that take this substantiation issue into consideration.

Degree of Compliance With Current Law

Despite the growing prevalence of employer-provided cell phones, there is anecdotal evidence that few employers fully comply with the current substantiation requirements – presumably due to compliance difficulties.

Proposed New Substantiation Methods

In recognition of the burdens of the current substantiation requirements (and likely because of its awareness of the low level of taxpayer compliance), the IRS has proposed three simplified methods to substantiate the business use of employer-provided cell phones.

  1. Minimal Personal Use Method – This method would allow employers to treat all of an employee’s cell phone usage as business usage, thus deductible to the employer and excludable from the employee’s income. Two variations of this method have been proposed. Under the first, employees would be required to provide the employer with records showing that he or she has a personal cell phone that is used for personal purposes during work hours. The second variation would permit an employer to disregard a specified amount or type of “minimal” personal use, by either designating a certain number of minutes of usage as for personal use or for certain personal purposes.
  2. Safe Harbor Substantiation Method – This method would allow employers to treat 75% of an employee’s cell phone use as business-related and the remaining 25% as personal.
  3. Statistical Sampling Method – This method would allow employers to measure an employee’s personal use according to statistical sampling techniques. The sampling would determine the percentage of use deemed to be personal and multiply that percentage times the value of each employee’s total use to determine the value of personal use.

Under all of these methods, employers would need to adopt a written policy that requires employees to carry and use an employer-provided cell phone in connection with their work and which prohibits use of the cell phone for any personal use other than “minimal use.” In addition, the employer would need to reasonably believe that employees used the employer-provided cell phone for business purposes and that any personal use was minimal.

The IRS is also considering how to develop a simplified valuation method in addition to simplified substantiation procedures and is seeking information on how employers currently determine the fair market value to an employee of an employer-provided cell phone.

The IRS has requested that written comments on both of these proposals be submitted to the agency by September 4, 2009.

Congress to Be Asked to Eliminate Personal Use Restriction

Finally, earlier this week and shortly after the issuance of Notice 2009-46, the Commissioner of the IRS issued the following statement, in which he explains the purpose of the Notice and makes a request to Congress:

This month, the Internal Revenue Service asked for comments on ways to simplify compliance with rules related to employer-provided cellular telephones. The current law, which has been on the books for many years, is burdensome, poorly understood by taxpayers, and difficult for the IRS to administer consistently. Some have incorrectly implied that the IRS is “cracking down” on employee use of employer-provided cell phones. To the contrary, the IRS is attempting to simplify the rules and eliminate uncertainty for businesses and individuals.

Although some of the proposed changes would add clarity, the current law will inevitably leave widespread confusion among employees and businesses. Therefore, Secretary Geithner and I ask that Congress act to make clear that there will be no tax consequence to employers or employees for personal use of work-related devices such as cell phones provided by employers. The passage of time, advances in technology, and the nature of communication in the modern workplace have rendered this law obsolete.

Impact on Employers

It is unclear where all of this leaves employers. As long as the current substantiation rules are in place, the IRS will continue to audit this issue, and employers and their employees are at risk (at least in theory) of adverse tax consequences if they do not comply with the rules. However, it appears that the IRS would like to see the law changed to eliminate any adverse tax consequences from personal use.

Unfortunately, the level of near-term Congressional interest and willingness to address the new IRS request (which would result in reduced tax revenues) is similarly uncertain. Accordingly, the best course of action for employers may be to review their current policies and practices, to carefully monitor developments in this area, and to prepare to implement one of the new simplified substantiation methods when and if they are formally adopted by the IRS.

For additional information, please contact the authors or any member of the McGuireWoods Employee Benefits or Labor & Employment teams.