Qualified Transportation Proposed Regulations
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Background of the Exclusion for Qualified Transportation Fringes
Under section 132(f), for purposes of determining the pre-tax maximum amount limits, there are two categories of fringe benefits:
(1) transportation in a "commuter highway vehicle"2 (including van pools) and transit passes3; and (2) qualified parking.4
For 2000, the monthly statutory limits for the two categories are $65 and $175, respectively. An employee may receive benefits
from each category, which means that for 2000 an employee may receive up to $240 a month in tax-free qualified transportation
fringes. The value of benefits exceeding the maximum amounts, if any, paid by the employer and the applicable amount excludable
under section 132(f) must be included in the employee's wages for income and employment tax purposes.
Until the January 2000 release of the Proposed Regulations, the only guidance that had been issued by Treasury was IRS Notice
94-3. The Proposed Regulations purport to "generally conform with the guidance in Notice 94-3," as well as reflect statutory
changes since 1994, and provide "additional guidance concerning the standards for determining when the section 132(f) exclusion
applies to cash reimbursement of transit pass expenses." Like the Notice, the Proposed Regulations are presented in Question-and-Answer
format.
In-Kind Transit Benefits
The most obvious loophole in the Proposed Regulations pertains to in-kind transit benefits. Q/A 9 of Proposed Treasury Regulation
' 1.132-9 ("Q/A __") provides that the value of a qualified transportation fringe must be calculated on a monthly basis to
determine whether the benefit has exceeded the applicable statutory monthly limit. The monthly exclusion amounts may not be
combined to provide a benefit in any month exceeding the statutory limit. In the case of in-kind transit benefits (other than
those provided through salary reduction), however, Q/A 9 offers the following generous rule:
In the case of a transit pass, the applicable statutory limit applies to the transit passes provided by the employer to the
employee in a month for that month or for any previous month in the calendar year.
(Emphasis added.) This ability to offer in-kind transit passes on a look-back basis is discussed in Example 2 of Q/A 9, wherein
Employee F, who was hired in January, receives tax-free transit passes in March totaling $195 (3 months times $65). The example
warns that this tax-free treatment would not have applied to the issuance of transit passes for January and February had Employee
F not been an employee during those months. However, the rule in Q/A 9, when coupled with Q/A 18,5 enables an employer to
issue transit passes to an employee for any previous month in the year in which the employee was actually employed (and with
respect to which no salary reduction election was in effect), without having to require certification by the employee regarding
his commuting use of the transit pass. In other words, at the end of the year, Q/As 9 and 18 enable employers to hand out
transit passes (not exceeding the statutory monthly limit) to each employee for each month of service during the year and
exclude the collective value of the transit passes from income (i.e., $780 worth of transit passes in 2000 for an employee
working the entire year (12x$65)). Because the employee does not have to certify that he incurred mass transit expenses, he
is apparently free to dispose of the passes as he sees fit - use them himself, give them to friends or family, or even sell
them. This absence of any prohibition on subsequent sale is in striking contrast to long-standing rules in other employee
compensation provisions that trigger immediate income (and deny any otherwise available tax exclusion), if an employee sells
property before it is vested.6
Salary Reduction Elections
The rules set forth in the Proposed Regulations for pre-tax salary reductions are also generous. Under section 132(f)(4),
the employer is permitted to offer employees a choice between cash compensation and any qualified transportation fringe pursuant
to a compensation reduction arrangement. Specifically, the employee has the right to elect whether he or she will receive
either a fixed amount of cash compensation at a specified future date or a fixed amount of qualified transportation fringes
to be provided for a specified future period (such as parking to be used in a future month). Q/A 12 (emphasis added).
It is curious that the IRS has been so liberal in permitting salary reduction elections at any time before the qualified transportation
fringe is to be provided for a specified future period, i.e., even the day before the period is scheduled to begin. Under
long-standing IRS ruling policy on deadlines for deferring compensation, salary deferral elections must be made before the
services are performed and often must be made in the prior calendar year. It is equally curious, as a policy matter, that
the IRS has drawn a distinction between benefits paid for by salary reduction and those paid by the employer directly. Under
case law, if a salary election is effective because it is made before the services generating the compensation are performed,
the compensation is simply employer-compensation and should be treated the same way as any other employer-provided compensation.
Applying this logic, if the employee has elected to reduce compensation by $240 month (to cover both parking and van pool
benefits) in each of the last three months of 2000, the employer should be able to hand out $720 in transit passes at year
end for 2000, assuming the employee was employed during the entire year. The Proposed Regulations, however, limit the amount
of in-kind transit passes that can be distributed at year-end to $65 a month for the last three months of the year, forcing
a carryover of the excess election amounts, which leads to the next surprising rule in the proposed regulations.
Carryover of Salary Reduction Amounts
An employee may carry over unused compensation reduction amounts to subsequent periods under the plan, including periods beyond
the calendar year. These carryover amounts may be used to reimburse the employee for qualified transportation expenses incurred
in a later month, provided the reimbursement does not exceed the applicable statutory monthly limit or the amount of expenses
actually incurred during the month of reimbursement. Q/A 15. Thus, if the employee does not use up the entire salary reduction
amount in any given month, the unused amounts may be carried over to future months, but may only be used to pay "qualified
transportation fringes."
As mentioned, since the term "qualified transportation fringes" covers transit passes, it appears that an employer can zero
out an employee's account at any point in time (e.g., at termination of employment) by handing out transit passes equal to
the carryover amount. This would also work in situations where the excess is carried over to the next calendar year.
This surprising rule (like the liberal changes in salary reduction election changes) again stands in striking contrast to
the very strict "use it or lose it" rule governing cafeteria plan benefits and to the "no cash or taxable personal benefit
option" applicable to IRC Section 62(c) business expense reimbursement plans. Plan administrators will no doubt have a difficult
time justifying to employees why those rules continue to be so harsh, when such liberal carryover rules apply to transportation
fringes.
Parking Valuation
One of the most notable differences between Notice 94-3 and the Proposed Regulations is the revised thinking with respect
to parking valuation. Sensibly, Q/A 20 defaults to the general valuation rule for fringe benefits found in the regulations
under Section 61 of the Code, i.e., the value of parking is based on the cost that an individual would incur in an arm's length
transaction to obtain parking at the same site. Other than referring to the general valuation rules, no other explanation
or examples are given in the proposed regulations. In contrast, much discussion was devoted to parking in Notice 94-3, because
of concern about the value of reserved parking being higher because of its availability to the employee even when not in use.
When asked about the Proposed Regulations' failure to address the employee's access to a reserved parking space as impacting
the benefit's valuation (see Q/A 10(d) of Notice 94-3), one Treasury official has stated informally that it was not the IRS's
intention to dismiss that factor as important when determining value. Therefore, until the regulations become final, it is
not clear how much weight employers should give to the very detailed explanation set forth in Notice 94-3.
Lack of Effective Date or Transition Rule
In the benefits area, it is not uncommon for proposed regulations to give immediate effective dates or at least indicate that
compliance with the Proposed Regulations will be viewed as evidence of good faith until final regulations are issued. Amazingly,
these new Q&As provide no effective date whatsoever, or any indication at all as to whether taxpayers can rely on these rules
for months and years before the rules take effect. By contrast, Notice 94-3 had provided a transition rule for benefits provided
before April 1, 1994, i.e., "efforts to comply with section 132(f) of the Code and to determine the fair market value of benefits
that differ from the rules contained in this notice will be considered reasonable good faith compliance so long as they are
based on a reasonable good faith interpretation of section 132(f)." Notice 94-3, Q/A 14.
Notice 94-3 was more concerned with substantiation requirements and valuation of qualified transportation fringes, whereas
the Proposed Regulations focus on salary reduction arrangements as a result of changes in the law. It will be extremely difficult,
however, for the IRS to refuse to apply rules at least as liberal as these proposed rules on a retroactive basis.
Employers should not be optimistic that final regulations will be issued in the near future. Thus, for at least many months,
and possibly for years to come, employers will be required to implement their qualified transportation fringe benefit plans
in accordance with the rules set forth in the Proposed Regulations, even though numerous issues are not adequately addressed.
However, in view of the many generous rules contained in these Proposed Regulations, it is likely that the number of employees
who will be participating in these plans will far exceed the IRS's curiously limited estimate of "7 million taxpayers" who
would be impacted by these rules.7 As word spreads among employee commuters about these generous rules, they are likely to
affect millions of commuters, in every city in the U.S. If you have additional questions concerning the administration of
your qualified transportation fringe benefit plans, please call Handy Hevener (202-682-7046) or Marianna Dyson (202-682-7058).
1. Proposed Treasury Regulation ' 1.132-9, 65 Fed. Reg. 4388 (Jan. 27, 2000).
2. A "commuter highway vehicle" must have a seating capacity of six, excluding the driver, and at least 80 percent of the vehicle's mileage must be reasonably expected to be used in transporting commuters. Section 132(f)(5)(C) and Prop. Treas. Reg. ' 1.132-9, Q/A Q-2.
3. Transit passes may be used for transportation on mass transit or in van pools.
4. To be qualified, parking must be provided on or near the employer's premises or at a location from which the employee commutes to work in a car/van pool or by mass transit. The parking may not be on or near property used by the employee for residential purposes. Q/A 4.
5. There are no requirements that the employee substantiate or certify the commuting use of transit pass distributed by the employer, provided the pass distributed for each month does not have a value exceeding the statutory monthly limit. Q/A 18.
6. See, e.g., Treas. Reg. ' 1.83-1(b)(1) (triggering immediate income on the sale of substantially unvested property); and Treas. Reg. ' 1.132-3(b)(1)(ii) (denying any exclusion under the employee discount rules where an employee disposes of discounted property other than by gift).
7. See 65 Fed. Reg. 4388, 4388 (Jan. 27, 2000), estimating that 7,264,970 "respondents" (i.e., employees) would participate annually in these plans.
© 2000 Weil, Gotshal & Manges LLP