On June 23, Proposed Treasury Regulations §§ 1.274-13 and 1.274-14 were published in the Federal Register addressing the disallowance of employer deductions for the cost of providing commuting and parking benefits to employees.  The proposed regulations are a mixed bag with some clarifications being helpful and others less so.  Proposed Treasury Regulation § 1.274-13 addresses the deduction disallowance under section 274(a)(4) for the cost of qualified transportation fringe benefits (QTFs) provided under section 132(f), i.e., qualified parking, transit passes, and other tax-free commuting benefits.  Proposed Treasury Regulation § 1.274-14 addresses the deduction disallowance for employee transportation costs under section 274(l).  Both deduction disallowance provisions were adopted as part of the Tax Cuts and Jobs Act (“TCJA”), and took effect for tax years beginning after December 31, 2017.

In 2018, IRS Notice 2018-99 provided extensive guidance on the calculation of the deduction disallowance under section 274(a) as it relates to qualified parking.  The proposed regulations provide some significant updates to Notice 2018-99 and respond to comments received on that Notice.  The preamble to the proposed regulations requests additional comments on a number of areas, some specifically raised by the COVID-19 pandemic.  The proposed regulations may be relied on by taxpayers for tax years beginning after December 31, 2017, and until the regulations become final, or taxpayers may choose to continue to rely on the guidance in Notice 2018-99.

General Principles

TCJA added new Section 274(a)(4) to the Internal Revenue Code to disallow the employer’s deductions for the cost of providing QTFs to employees, as defined in Section 132(f).  QTFs are excluded from an employee’s gross income up to an inflation-adjusted monthly limit ($270 in 2020).  This statutory limit applies to all QTFs, but the proposed regulations focus on calculating the disallowance for expenses related to qualified parking, which has proven more difficult for employers to determine.  Qualified parking is parking provided to an employee on or near the business premises of the employer, or on or near a location from which the employee commutes to work.

Compensation Reduction Arrangements.  The proposed regulations reaffirm the IRS’s position that QTFs provided through a compensation reduction agreement are subject to the deduction disallowance of section 274(a)(4).  Some commentators had suggested that there should not be a deduction disallowance for an otherwise deductible expense as a result of the employee’s election to use some compensation to purchase qualified parking on a pre-tax basis.  However, the IRS reasoned that the disallowance of section 274(a)(4) should apply when the value of the QTF is not included in the employee’s gross income, because the employer incurred an expense for an excludable QTF rather than an expense for compensation.

Application of Section 274(e).  Section 274(e) provides a number of exceptions to the deduction disallowances under section 274(a), including the disallowance for the costs of providing QTFs.  In particular, the proposed regulations identify three exceptions that could apply to the provision of QTFs.  As discussed below, section 274(e) does not operate to eliminate the deduction disallowances imposed under section 274(l).

Section 274(e)(2) provides an exception to deduction disallowance for costs actually treated as employee compensation and included in the employee’s gross income.  The proposed regulations provide that this exception does not apply to expenses paid or incurred for QTFs the value of which does not exceed the sum of the amount excluded from the employee’s income under section 132(a)(5) and any amount paid by the employee for the QTF. This tracks the rule under section 61 for determining the amount that must be imputed to an employee as income based on the value of a non-cash fringe benefit. This provision would preclude an employer from taking the position that, because the parking provided to employees has no value, the provision of parking is not a QTF that would result in a deduction disallowance.  In the case where the employer’s cost of providing a QTF exceeds the value of the QTF to the employee, the proposed regulation would appear to preclude an employer from arguing that the employer is entitled to deduct the cost in excess of the value of the QTF.  In other words, the employer cannot argue that the excess cost is excluded from the disallowance by operation of section 274(e)(2) since such amount was not required to be included in the employee’s income under section 61 unless the employer uses the qualified parking limit method described below.  This is similar to the position of the IRS in Sutherland Lumber-Southwest, Inc., in which the IRS argued that the employer should not have deducted the costs of personal flights in excess of the amounts required to be imputed under the section 61 special valuation rule applicable to noncommercial flights.  The IRS’s loss in Sutherland-Lumber led to statutory changes to Sections 274(e)(2) and 274(e)(9),  adopting the IRS’s deduction-disallowance position with respect to entertainment flights provided to certain specified individuals.

Sections 247(e)(7) and (e)(8) provide exceptions to the 274(a)(4) deduction disallowance for expenses for transportation in a commuter highway vehicle, transit passes, or parking that is made available to the general public or sold to customers, respectively.  As discussed in greater detail below, the general public does not include employees, partners, 2-percent shareholders of S corporations, sole proprietors, or independent contractors of the taxpayer, but it does include customers and guests of the taxpayer.   Further, section 274(e)(8) exempts from the deduction disallowance expenses for commuting or parking sold to the public for fair market value.  This means that a bus company, or another public transit provider, would not be precluded from deducting expenses related to the services bought by its own employees for fair value.

Importantly, the deduction disallowance would presumably not apply if the fringe benefit could be excluded from income under another provision of the Code.  For example, if a train or bus operator allowed its employees to commute on a space-available basis using its services, the value of the commute could be excluded from income as a no-additional-cost service.  Accordingly, the disallowance under section 274(a)(4) would not apply to such benefits because their value is excluded under section 132(b) rather than under section 132(f).

Four Methods for Calculating Deduction Disallowance for Qualified Parking

To determine the amount of the deduction disallowance, the taxpayer starts with the taxpayer’s expenses related to parking. The proposed regulation generally define “total parking expenses” in the same manner as Notice 2018-99 to include all expenses related to all of the parking spaces in a parking facility.  A non-exhaustive list of costs includes repairs, maintenance, utility costs, insurance, property taxes, interest, snow and ice removal, leaf removal, trash removal, cleaning, landscape costs, parking lot attendant expenses, security, and rent or lease payments or a portion of a rent or lease payment (if not broken out separately).  Fortunately, the proposed regulations reaffirm, contrary to the Joint Committee on Taxation’s summary of the TCJA, that the deduction disallowance does not apply to depreciation.  This exclusion of depreciation from the total expense calculation is based on case law holding that depreciation is not an expense or cost incurred, but represents wear and tear.  Section 274(a) disallows only costs incurred.  This may encourage taxpayers to identify expenses that may be classified as improvements to parking facilities rather than maintenance.  The definition of parking expenses also excludes costs related to items next to, but not located on, the parking facility, reaffirming the position in Notice 2018-99.

In general, if an employer pays a third party for its employees’ QTFs, the disallowance is equal to the total amount paid to the third party for the QTFs.  However, the proposed regulations provide four methods of calculating the deduction disallowance for expenses related to qualified parking under section 274 when the taxpayer owns or leases the parking facility.  A taxpayer may choose any of the four methodologies each tax year and for each facility, i.e., the taxpayer may choose the most beneficial method of calculating the disallowance for each location and may change the method annually.  The four methodologies are the “General Rule,” and three simplified methodologies: the “Qualified Parking Limit Method,” the “Primary Use Method,” and the “Cost Per Space Method.”

General Rule.  The “General Rule” permits a taxpayer to calculate the deduction disallowance  based on a reasonable interpretation of section 274(a)(4).  The taxpayer may not (i) consider the value of the parking to the employee, but instead must use the actual costs incurred, (ii) deduct expenses related to parking spaces reserved for employees, or (iii) treat a parking facility regularly used by employees as available to the public merely because the public has access to the parking facility.  This last limitation is perplexing at first glance, as a parking facility to which the public has access would seem to be available to the public.  However, the preamble to the proposed regulations explains that this limitation is related to the section 274(e)(7) exception for parking available to the general public and that, if greater than 50% of the parking facility is used by employees, it would be unreasonable to exclude the expenses from the calculation of the deduction disallowance.  In other words, a taxpayer may not treat an entire parking facility as available to the public under section 274(e)(7) unless more than half of the facility is available to the public and it has no more than a de minimis number of reserved employee spaces.

Qualified Parking Limit Method.  The “Qualified Parking Limit Method” allows a taxpayer to calculate the deduction disallowance by multiplying the total number of parking spaces used by employees during the peak demand period, or the total number of taxpayer’s employees, by the section 132(f)(2) monthly exclusion limitation (e.g., $270 in 2020) for each month in the taxable year.  Although simple to apply, this methodology is likely to result in a higher disallowance amount than the other methods.  If, however, the employer’s cost of providing the parking exceeds the value of the parking provided to its employees, this method could result in a lower disallowance, as under this method, the employer is permitted to deduct expenses in excess of the monthly section 132(f) limit.  However, the taxpayer cannot assert that, because the cost below the monthly limit but in excess of the value of the parking was not required to be imputed to the employee, such amount is not subject to disallowance under section 274(e)(2). A taxpayer may only use this methodology if the taxpayer includes any value in excess of the limit on the exclusion of qualified parking in the employees’ compensation.

Primary Use Method.  The “Primary Use Method” adopts the four-step methodology laid out in Notice 2018-99 with some significant changes, as follows:

Step 1.  The taxpayer calculates the disallowance for reserved employee spaces by calculating the percentage of those spaces in relation to total parking spaces and multiplying that percentage by the taxpayer’s total parking expenses for the parking facility.  Based on comments on Notice 2018-99, the proposed regulations provide a new de minimis rule eliminating the deduction disallowance for reserved parking spaces if: more than 50% of the available spaces are for use by the general public, there are fewer than 5 reserved spaces for employees, and those 5 reserved spaces are less than 5% of the total parking spaces.  (Available parking spaces for this purpose do not include reserved employee parking spaces or those that are unusable or used for inventory, e.g., spaces taken by cars for sale at a car dealership.)  This rule permits employers to provide a limited number of executives or an employee of the month a parking spot without the administrative burden or tax liability associated with such de minimis use.

The proposed regulations define the term “general public” to include customers, clients, visitors, individuals delivering goods or services to the taxpayer, students of an educational institution, and patients of a health care facility.  The proposed regulations favorably clarify the treatment of unrelated businesses in an office park or office building.  If a taxpayer owns or leases space in a multi-tenant building, the general public includes employees, partners, 2-percent shareholders of S corporations, sole proprietors, independent contractors, clients, or customers of unrelated tenants in the building.  The general public does not include individuals that are employees, partners, 2-percent shareholders of S corporations, sole proprietors, or independent contractors of the taxpayer.  Also, an exclusive list of guests does not qualify as the general public.

Step 2.  The taxpayer determines the primary use of the available parking spaces by calculating the percentage of parking used by employees, even if held open to the general public, during peak demand hours.  If less than 50% of the parking facility is primarily used by employees, expenses allocable to the available parking spaces are excepted from the section 274(a)(4) disallowance, and no further calculations are required.

Step 3. If more than 50% of the parking facility is primarily used by employees, the taxpayer determines the amount of spaces reserved for nonemployee parking as a percentage of total available parking spaces and multiplies that percentage by its total parking expenses.  The product of that calculation is excepted from the section 274(a)(4) disallowance because it is not for qualified parking.

Step 4. If the taxpayer has remaining parking expenses not specifically categorized as deductible or nondeductible, the taxpayer allocates those amounts to the total available spaces used by employees during the peak demand period (discussed below) to determine any further disallowance.

Cost Per Space Method.  The “Cost Per Space Method” permits the taxpayer to multiply its per-space total parking expenses by the total number of available parking spaces used by employees during the peak demand period.  The product is the amount of the total parking expense deduction disallowance under section 274(a)(4).  The taxpayer may calculate its per-space cost by dividing total parking expenses by the total number of parking spaces.  This methodology eliminates the need to separately account for reserved employee spaces and reserved non-employee spaces.

Special Rules for Calculating Deduction Disallowance

The proposed regulations provide special rules for calculating the disallowance using the four methods.  These rules relate to expenses that are incurred on behalf of both parking and nonparking facilities, the aggregation of multiple parking facilities in a geographic area, and the determination of the peak demand period for the parking facility.

Mixed Parking Expenses.  For mixed parking expenses, i.e., expenses that are incurred by a taxpayer for the benefit of both parking and nonparking facilities that the taxpayer owns or leases, a taxpayer may choose to allocate 5% to parking expenses.  Examples of mixed parking expenses include property taxes, interest, utilities, and insurance, that are not segregated between parking and nonparking facilities.  This 5% allocation method may only be used, but is not required to be used, in conjunction with the Primary Use Method or Cost Per Space Method.

Aggregation of Parking Facilities.  Employers that own or lease multiple parking facilities for employees at a single geographic location may aggregate all of the parking spaces in each facility for purposes of determining the total parking spaces.  The proposed regulations define “geographic location” as contiguous tracts of land, or those that would share a boundary if it were not for a road or similar divider.  Sharing a common corner point does not make the tracts contiguous.  This is a significantly narrower rule than the parking facility aggregation allowed under Notice 2018-99, and will increase both administrative burden and expense allocation.  This aggregation rule will also preclude use of a method advocated by some consultants that public-facing operations, such as retail facilities, could be aggregated with office facilities in the same city or larger area to avoid any disallowance under the primary use approach in Notice 2018-99.  This parking space aggregation method may only be used, but is not required to be used, in conjunction with the General Rule, Primary Use Method, or Cost Per Space Method.

Peak Demand Period.  “Peak demand period” is the time during the typical business day during which the largest number of employees are at work, not including any brief overlap during a shift change.  A taxpayer may use any reasonable method to estimate this period, including periodic inspections or employee surveys.  The IRS has requested comments on how national emergencies, such as the COVID-19 pandemic, may affect this determination and whether special rules need to be in place to assist in making such determinations.

Disallowance of Transportation and Commuting Expenses under Section 274(l)

Proposed Treasury Regulations § 1.274-14 addresses the disallowance of deductions under section 274(l) for amounts paid or incurred after December 31, 2017, for any expense incurred to provide any transportation, or any payment or reimbursement, to an employee of the taxpayer in connection with travel between the employee’s residence and place of employment, except as necessary for ensuring the safety of the employee.

The proposed regulations do not define “place of employment.” This leaves open the question of whether the costs of daily transportation between an employee’s residence and temporary work location, which may be excluded from the employee’s wages as a working condition fringe benefit under Revenue Ruling 99-7, are subject to disallowance under section 274(l).  Moreover, an example in the proposed regulations suggests that there is no exception to the deduction disallowance merely because the value of the transportation is included in the employee’s income.  Accordingly, if an executive lives in one city, commutes via corporate jet to another city on a weekly basis, and the value of those trips is treated as compensation, the costs associated with such trips would appear to be disallowed under section 274(l).  Similar concerns exist with black car service provided to executives (subject to the exception discussed below for employee safety).  Even a portion of the cost of employer-provided vehicles could be disallowed under section 274(l) if the employee uses the vehicle for commuting regardless of whether the employer imputes income to the employee under the special valuation rules for valuing personal commuting benefits in an employer-provided vehicle.

Interestingly, the proposed regulations do define the employee’s residence by reference to Treas. Reg. § 1.121-1(b)(1), which includes a fact and circumstances test to determine the location of a taxpayer’s residence.  Expenses incurred for transportation that begins at a transportation hub near the employee’s residence, e.g., a subway station or airport, are also subject to disallowance.  In other words, a taxpayer cannot avoid the disallowance by having an executive arrange transportation to the airport at the executive’s own expense and arguing that the trip is not from the employee’s residence to the place of employment.

The proposed regulations provide an exception to the deduction disallowance for transportation expenses incurred when there is a bona fide business-oriented security concern.  The validity of this security concern is determined by reference to Treas. Reg. § 1.132-5(m), which provides that, in general, such a concern exists only if the facts and circumstances establish a specific basis for a safety concern regarding an individual employee.  This generally requires the employer to obtain a security study from an outside security consultant to document the security concern or to provide 24-hour protection to the employee.  This view of a security concern is narrower than if the IRS had relied on the de minimis fringe benefit exclusion for local transportation provided due to unsafe conditions or the special valuation rule under section 61 for employer-provided transportation due to unsafe conditions.