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Tax requirements and business cell phone use

By Marianna G. Dyson and Michael M. Lloyd

From the October 2006 edition of Thompson's Employer's Guide to Fringe Benefits Rules

In the past 17 years, the number of cellular telephone users in the U.S. has skyrocketed. No longer resembling suitcases or hardwired into automobiles, people transport them in handbags, clipped to belts and in pockets. Many cell phones now resemble Star Trek communicators while others resemble miniature computers (e.g., Blackberry devices). In fact, technology has evolved to such a degree that most cell phones now tout features such as global positioning systems (GPS), Internet access, cameras, email and MP3 players. Cell phone use has become so engrained in daily business that even IRS personnel use them in their daily jobs.

Unfortunately, federal tax rules have failed to keep pace with the business use of cell phones. In April 2005, the IRS issued an indirect reminder of the inconvenient substantiation rules applicable to providing employees with the phones or reimbursing employees for their use. The reminder was part of the IRS "Audit Techniques Guide on Executive Compensation and Fringe Benefits," which reminds IRS field examiners that cell phones (or other similar telecommunications equipment) constitute "listed property" under Code Section 280F(d)(4)(A)(v). (See ¶462 of the Employer's Guide to Fringe Benefits Rules for more on cell phones and the substantiation rules applicable to them.)

Accordingly, employers must document employee business usage in order to deduct the purchase and operational costs of the phones and to exclude the value of their business use from employee income as working condition fringe benefits under Section 132(d) or reimbursements under the accountable plan rules of Section 62(c). (See ¶400, App. A and ¶741, respectively, for more on working condition fringe benefits, Section 132 and accountable plans.)

Cellular Telephones Are "Listed Property"

Congress added cell phones to the definition of "listed property" in 1989. "Listed property" refers to property specifically listed in Section 280F(d)(4) and that inherently lends itself to personal use, such as cars. Much has changed since then, however. For example, in 1989 the number of cell phone users amounted to a small fraction of today's users, the cost of the phones far exceeded that of today's devices and Congress doubted the use of such technology in daily business activities.

The incorporation of cell phones into the meaning of "listed property" limits the use of accelerated depreciation rules in certain instances unless the taxpayer substantiates the phone's business use through adequate records or by sufficient evidence corroborating the taxpayer's own statement with the following:

  • the amount of the expense or other item,
  • the time and place of the use of the property,
  • the business purpose of the expense, and
  • the business relationship to the taxpayer using the property.

To determine business use percentage and withstand audit scrutiny, employers must collect and retain monthly statements, which generally set forth the amount of the expense, the time and date of each call and the number dialed. To the extent that employees can demonstrate calls placed to customers or clients, the business purpose and business relationship should withstand scrutiny. Failing to maintain adequate documentation may result in lost deductions and possible Federal employment tax (federal income tax withholding, federal unemployment taxes, and Social Security and Medicare (FICA, see ¶105)) assessments for employers.

The Real Exposure

Based upon the legislative history of Section 280F(d)(4)(A)(v), Congress added cell phones to the meaning of "listed property" to limit the use of accelerated depreciation on cell phone purchases. The accelerated depreciation of the telephones, however, now generally represents a pittance compared to the cost of service and usage fees.

For example, an average cell phone generally costs between $100 and $200, but it is not uncommon for monthly service fees to average $85 or more per month ($1,020 per year). The IRS has recognized that service fees represent the most significant exposure area for taxpayers, and examiners regularly pursue this issue on audit. The courts have consistently held for the IRS when taxpayers fail to substantiate cellular telephone deductions.

What Employers Can Do to Comply

To comply with existing tax rules, employers must either satisfy the onerous substantiation requirements by requiring annotated monthly statements from employees to support deductions and employee income exclusions or they must treat the value of the benefits as wages for Federal employment tax purposes and report this value as wages on Forms W-2.

For practical reasons, some employers opt to reimburse employees for cell phone purchases on an after-tax basis to negate the employer's ownership of the phones and the requisite fixed asset tracking that follows. Employers should also provide reimbursements of service and usage fees on an after-tax basis unless they collect annotated documentation from employees to substantiate the reimbursements in accordance with Section 274(d)(4).

There are no streamlined substantiation rules (e.g., the "no personal use" and "de minimis personal use" exceptions from substantiation) applicable to listed property other than cars. Some employers have successfully applied the sampling approach to satisfy the documentation requirement for cell phones. Sampling is permitted by Treas. Reg. §1.274-5T(c)(3), which provides that an employer can demonstrate by other evidence that the periods for which adequate records are maintained are representative of the use of the listed property for the year in question.

Employers should either collect all monthly statements from employees or, at a minimum, require employees to maintain those records in order to effectively respond if the IRS inquires into the validity of the sampling.

Marianna G. Dyson, Member, Miller & Chevalier Chartered; she practices in the areas of tax and employee benefits with a focus on consulting, tax audits and appeals controversies involving noncash fringe benefits, employment taxes and accountable plans. She also is a member of the Editorial Advisory Board that serves the Guide. Michael M. Lloyd is a Senior associate at Miller & Chevalier Chartered; he practices in the areas of tax and employee benefits with a focus on federal and state tax issues, including employment tax reporting, treatment of fringe benefits and executive compensation.