In his recent State of the Union address and accompanying budget, the President offered an ambitious agenda, calling for a substantial amount of new spending, tax cuts, saving social security and Medicare, and paying down the national debt.  However, with Congress controlled by the Republicans, it is unlikely that very much of his program will be passed.  The speech was as much an election document as a blueprint for legislation.

The Current Lay of the Taxation Land

The President proposed more than $350 billion in gross tax relief with about $100 billion in offsets.  Most of the tax provisions would be targeted to the middle class.  Among the issues to be addressed include:

• reducing the marriage penalty by increasing the standard deduction;
• promoting savings by making investing in retirement programs easier;
• increasing benefits for child care and making the credit refundable;
• providing nonitemizers a deduction for charitable contributions;
• expanding the earned income tax credit, tax cuts for college expenses, long-term care credit and health coverage; and,
• providing alternative minimum tax relief for individuals.

Unless legislation is passed quickly, it is unlikely to be passed at all.  The election looms, and both parties will be breaking during the summer for their respective conventions.  A very small window exists for any bipartisan action.  While it may not be interesting theater for the general populace, there are some tax issues that will have an immediate impact on the hotel industry and its clients.

Back on TRAC for Reporting Tips

The hospitality industry has been fighting with the IRS for years over whose responsibility it is to ensure that employees properly report tips.  The Service believes that many employees do not report the tips received, and employers have little incentive to encourage compliance.  Therefore, the Service has established several programs to combat the abuse.

Several cases have come down concerning the tax treatment of tips and the ability of the IRS to assess FICA tax on restaurants for unreported tips by the wait staff.  The IRS has won more often than not.  Taxpayers claim that the IRS lacks authority to assess the employer’s share of FICA taxes without first investigating individual employees to determine whether underreporting actually occurred.  Generally, the Appellate Courts have held that tips are treated as having been paid by the employer, and the IRS can assess the employer’s share when the employee fails to report all tips.  With the IRS’s success in the cases, more restaurants may consider entering into the Tip Reporting and Compliance (TRAC) program.  This program is an administrative attempt to reduce the financial and resource burdens of both the IRS and employers when tipped employees fail to report all of their tips.

A restaurant in the program agrees to establish a program to educate its employees, comply with all reporting responsibilities, maintain records, and set up a procedure for employees to report tips.  Under the extension to the program, the IRS has promised to reduce the employer’s liability and go after the employee directly if tips are underreported, despite the employer’s best efforts.  This change should make the plan more palatable to employers and may increase participation.  The IRS announced the extension of its TRAC program until May 31, 2005.

Where’s the (Tax-) Free Lunch?

Generally, the value of free or discounted meals provided to an employee is taxable unless a specific exception applies.  An employee meal provided on the employer’s business premises for the convenience of the employer is one of the exceptions.  The IRS frequently challenges the convenience of the employer exception, particularly in the hospitality industry.

To qualify, a meal must be furnished for a substantial noncompensatory business reason of the employer.  Among the reasons set forth in regulations are that the employees are restaurant and food service employees, or there is an inability to obtain a meal within a reasonable period (such as insufficient eating facilities), or the employees have a restricted meal period, or they are on emergency call.

The determination is made on an employee-by-employee and meal-by-meal basis.  One change made by a recent tax bill is a special statutory rule.  When a majority of employees are covered by the exception, all meals served to employees will be treated as furnished for the convenience of the employer and fully deductible.  Previously, the IRS had a “substantially all” requirement which it interpreted as at least 80 percent.

In 1997, the Tax Court ruled that a taxpayer’s deduction for meals provided to employees for the convenience of the employer were limited to 80 (now 50) percent of the related expense.  The Court also called into question whether the meals were provided for a substantially noncompensatory reason.  If not, the value of the meals must be included in the income of the recipients and subject to employment taxes.  Recently, the Ninth Circuit overruled the Tax Court on both issues.  The taxpayers are hotel and casino operators.  For reasons of security and logistics, they required their employees to stay on the premises during the work shift.  As a consequence, the employees receive free meals at on-site cafeterias.

The taxpayer contended that its meals were not subject to the eighty-percent cap because the meals are provided as a de minimis fringe benefit.  While the Tax Court disagreed, the Ninth Circuit did not.  It concluded that the “stay on premises” requirement, once instituted, made the furnished employee meals indispensable to the proper discharge of the employees’ duties.  The Court made no distinction between employees isolated because of geography (which the IRS accepts) and those isolated because of employer policy.

The Court did caution that one could not establish a policy merely to obtain a deduction.  However, the taxpayer had valid reasons for the policy, and the Court did not feel that it should second-guess the employer’s reasons or to substitute its business judgement for that of the taxpayer.  The deduction, at 100 percent, was allowed.

eCOMMERCE tax

While perhaps less immediate than tip reporting and employee meals, the issue of taxing e-commerce promised to have wide-ranging effects on all businesses, not the least of which are hotels and travel companies.  Hotel companies have seen the value of the Web for years.  Every major brand has its own Web site   For the travel industry, 1999 saw a boom in the use of the sites to make reservations and purchase tickets.  It also saw consumers increase the purchase of all types of goods online.  In spite of the concerns that shoppers have in giving credit card information over the Net, many businesses saw a dramatic increase in the number of hits to their sites, as well as actual orders.  While many of the dot-com businesses were new, the popularity of this method of shopping required many established vendors to offer this method of purchasing.  The online companies were not without problems, as complaints of no or late delivery, as well as a lack of inventory, were rampant.

In addition to the growth by individual consumers, businesses also began using the Web for purchases.  Businesses can purchase anything from office supplies to computers to the little bars of soap that go into hotel rooms.  If a business needs a product, it can be found on the Web.  One concern to state governments is the absence of a tax on most purchases.  Most feel that, with the explosion in online companies, the states’ tax bases will be dramatically impacted.  For many, sales tax is one of the largest revenue generators, second only to the income tax.  Since an online business may not have a location in the state, no sales tax is collected at the source.  Use taxes could be a substitute, but the States are not convinced that consumers would pay them.

A three-year moratorium that does not allow any new taxes on the Internet is currently in effect.  Several members of Congress have introduced bills to make this moratorium permanent, and a commission has been established to study the issue and report back to Congress.  The commission is divided on whether to place a permanent ban on the taxes or come up with a more equitable, and simple, method of collecting the various state sales taxes.  Online vendors believe that any requirement to tax would be a blow to the digital economy.  Meanwhile, local suppliers complain that they are losing sales because they have to collect tax.  A compromise would seem to be to everyone’s advantage, but if the catalogue industry is any indication, any compromise will be hard to come by.

While the above issues may not be as exciting as following legislation that has little chance of passage, they likely will have a greater impact on hotels.  With the Internal Revenue Service and the courts continuing to modify their interpretations of existing tax law, and Congress continuing to legislate, tax planning for hotels is all the more difficult, while at the same time, all the more critical.

Mr. Reilly is the U.S. National Director of Taxation and Managing Director for the Washington office of PKF Worldwide, business advisors to the hospitality industry.