How much should an employee recognize as income when his/her employer provides the employee with tax preparation services? That was the question addressed by Chief Counsel Advice 201810007.
The employer in this case had U.S. citizens that were given work assignments in various other countries, with employees also being relocated from time to time. As is often the case in such situations, the employer decided to provide a “tax equalization” program. Under such a program, the employer agrees to compensation employees in such a fashion that their after-tax income will not fluctuate as they move from taxing regime to taxing regime.
Rather the employer will determine what the employee’s after-tax income would have been if the employee had been working in the United States. The employer then increases or decreases the employee’s salary as the employee moves from location to location to achieve the same after-tax income.
Since tax calculations are very fact dependent and can’t really be calculated until after the tax years end for all of the taxing authorities, during the year the employer pays an amount it will believes will “equalize out” at year end—that is, after the foreign taxes are paid and the U.S. return is prepared, with the U.S. return taking into account the foreign earned income exclusion, foreign tax credit and/or foreign tax deduction as appropriate. Once the actual returns are prepared, the employer either pays additional compensation to the employee (assuming it turns out more was owed than had been contemplated) or the employee reimburses the employer (if the tax comes to less than was projected).
Of course, the tax returns that end up being prepared are generally going to be far more complicated in nature. These complications mean that the employee likely would not be able to use the same system he/she would have used to have the returns prepared as they would have had they stayed in the U.S. As well, the employer is going to want to ensure that the returns they are using to determine the equalization payments are prepared by a party that the employer believes is skilled enough to accomplish the task.
Thus, employers in these situations will generally agree to have the employee’s returns prepared by an international accounting firm who, in addition to handling all the employee’s returns (U.S. and other countries), will perform various calculations for the employer to compute the equalization amounts for the various employees as well as help implement the program.
Many of the employees had tax situations where, had they been working in the U.S., their returns would have been extremely simple (a Form W-2, a couple of 1099s for interest and dividends, as well as a few itemized deductions on Schedule A). Prior to being assigned outside the U.S. they may very well have used off-the-shelf consumer tax software to prepare their tax returns. Certainly, they would not have taken their returns to an international accounting firm to have it prepared, nor would such firms have been actively soliciting such clients.
The employees are clearly receiving a service (having their tax return prepared) as part of their compensation and the employer recognized that the value of that service should be taxable to the employee. But the question now becomes what amount should be treated as the value of having the return completed for the employee?
The employer reasoned that the value should be approximately what the employee would have paid to have his/her return prepared by a tax professional had the employee still resided in the U.S. The employer reasoned that the need for the returns for other countries arose only because of the action of the employer in assigning the employee to the non-U.S. location.
The international firms are not generally soliciting the sorts of U.S. returns that these employees would have been filing had they been located in the U.S., so, per the memorandum, the employer used the following methodology to compute the amount to include in the employee’s income:
For federal employment tax purposes, Taxpayer valued the United States and state tax return preparation services provided for the benefit of its assignees at $* * * per year, and imputed this value as income and wages to its assignees. Taxpayer imputed no income or wages to its assignees in connection with the value of the employer-provided foreign tax return preparation services.
In valuing the United States and state tax return preparation services, Taxpayer relied, in part, on:
(1) A * * * survey conducted by the National Society of Accountants regarding the average tax preparation fees for an itemized Form 1040 with Schedule A and a state return; and
(2) A * * * Notice * * *, published by the United States Treasury Department (“Treasury Department Notice”), which estimated the average time burden and average cost of preparing a Form 1040, 1040A, or 1040EZ return.
The amount the firm was billed by the international accounting firm included several services beyond simply preparing the individual’s Form 1040 and state returns. The services the international CPA firm provided were outlined as follows in the memorandum:
In connection with its tax equalization policy, Taxpayer engaged CPA Firm to assist with assignees’ tax matters. CPA Firm is a large, multinational accounting and consulting firm. Taxpayer's tax equalization policy provides that the following services will be performed by CPA Firm with respect to tax-equalized assignees:
(1) Preparation of foreign, United States, and state tax returns;
(2) Computation and payment of the approximate and actual hypothetical tax and tax equalization settlements;
(3) Respond to inquiries from taxing authorities, as related to the foreign assignment;
(4) Global coordination of the assignment program; and
(5) Provide advice and instructions to Taxpayer's payroll department regarding how to report and tax appropriately.
The IRS agents examining the employer’s payroll tax returns did not believe the employer’s valuation of the services received by the employer was appropriate. The agents objected to the employer not counting any value for the preparation of non-U.S. tax returns as compensation. As well, the IRS noted that the international firm was charging amounts, even for preparation of the U.S. returns, that were far more than the employer’s computed value.
The memorandum generally agreed with the agents’ position on these matters. First, the memorandum found there was no basis under the law for excluding the value of the foreign returns the employee was legally obligated to file. The memorandum argues:
…[T]he assignees received the same or similar personal benefit from having their foreign tax returns prepared as they did from having their domestic returns prepared, and were personally obligated to file complete and accurate tax returns, there is no valid basis for excluding the value of the foreign tax preparation services from gross income while including the value of the domestic tax preparation services. Expenses paid or incurred by a taxpayer in connection with the determination, collection, or refund of a foreign tax are deductible under § 212(3) in the same manner as expenses paid or incurred in connection with the determination, collection, or refund of a domestic tax. See Sharples v. United States, 533 F.2d 550 (1976). Like the employer-provided financial consulting services described in Rev. Rul. 73-13, the receipt of the Taxpayer-provided tax preparation services (both for the domestic and foreign returns) conferred a direct and personal benefit on the assignees, and the value received must be included in the assignees' gross income under § 61.
The IRS noted that to be a “working condition fringe” excludable from the employees’ income under IRC §132, at a minimum the expense would have to have been deductible, if paid by the employee, as a business expense under IRC §162. But tax preparation is specifically only deductible for an individual under IRC §212(3). So, the employer’s argument that the foreign return as a work-related fringe benefit did not allow for exclusion from the employee’s income (or from FICA/Medicare taxation for the employer) was incorrect.
The memorandum also agreed with the agents’ view that using the value for preparation a return that was based on a) a return that was much less complex than the employee’s actual return and b) ignoring the fact that the employer was paying far more than that amount for the returns that were prepared was not appropriate.
The memorandum initially holds that, in fact, the amount the employer was paying was less than the true fair value of what the employee received. The international CPA firm had agreed to charge a discounted price for preparation of the returns based on the volume of returns the firm would be preparing. An individual looking to get his/her own returns prepared would not be able to obtain that volume discount.
The memorandum notes:
Neither the average tax preparation fee for an itemized Form 1040 with Schedule A and a state return according to the * * * survey conducted by the National Society of Accountants, nor the Treasury Department Notice estimating the average time burden and cost for all taxpayers filing a Form 1040, 1040A, or 1040EZ, represent an adequate measure for determining the fair market value of the tax preparation services the assignees in this case received. These assignees received sophisticated tax return preparation services from a large, multinational accounting and consulting firm with respect to both domestic and foreign tax returns. The fair market value of those services is the amount that the same or a similar large, multinational accounting and consulting firm would charge an individual employee for the same services in an arm's length transaction.
But the memorandum does recognize one significant problem with coming with this theoretically “pure” and “correct” value for the returns:
Unfortunately, data regarding arm’s length transactions between individual employees similar to the assignees and large, multinational accounting and consulting firms similar to the CPA Firm for the same type of tax return preparation services is not generally available. Large, multinational accounting and consulting firms like the one utilized by Taxpayer in this case, which provide premier international tax consulting services, do not typically have individual employees like the assignees in this case as tax return preparation clients. Instead, large companies, like Taxpayer, enter into contracts with multinational accounting and consulting firms, like CPA Firm, to provide tax preparation services for numerous employees stationed in various countries throughout the world.
Given this constraint, the memorandum reluctantly concludes that the most appropriate value for the services received by the employee will be the amount the employer paid for the following services for each employee that the IRS agents had determined were services provided to the employees in this situation:
- Preparation of basic domestic United States tax returns — 1040, 1040 NR, and first state return;
- Sourcing of compensation for Federal income tax purposes and the employee's foreign tax credit;
- Sourcing of compensation for nonresident and part-year resident state income tax purposes;
- Preparation of Form 1116 (Foreign Tax Credit) and Form 255 (Foreign Earned Income);
- Optimization of foreign earned income exclusion or foreign tax credit position;
- Coordination with foreign tax return preparer to confirm globally consistent approach to residency positions, treaty articles, etc.; and
- Notification to employees of foreign bank account reporting (FBAR) obligations if they had overseas financial accounts related to foreign assignment.