The Department of the Treasury and the Internal Revenue Service (IRS) have issued proposed regulations (REG-132805-17) concerning the determination of an employer’s line of business for purposes of applying the exclusion from gross income for no-additional-cost services and qualified employee discounts under Internal Revenue Code (IRC) Section 132. These proposed regulations are intended to update the business classification system used for these fringe benefits to better reflect current economic activity and reduce administrative burden.

Statutory Nature of the Fringe Benefit Exclusions

IRC Section 132(a)(1) and (2) provide for the exclusion from an individual’s gross income of certain fringe benefits, specifically no-additional-cost services and qualified employee discounts, respectively.

A "no-additional-cost service" is defined, in part, by IRC Section 132(b) as any service provided by an employer to an employee for use by that employee, provided such service is offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services.
A "qualified employee discount" is defined by IRC Section 132(c)(1) with respect to qualified property or services. IRC Section 132(c)(4) further defines "qualified property or services" as any property (excluding real property and personal property held for investment) or services offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services.

A crucial limitation for both exclusions is that the individual receiving the fringe benefit must have performed substantial services in the employer’s line of business that offers such services or property for sale to customers in the ordinary course of business. The proposed regulations are issued under the authority conferred by Section 132(o), which grants the Secretary the authority to prescribe necessary or appropriate regulations, and Section 7805(a) of the Code, which authorizes needful rules and regulations for Code enforcement.

Key Differences from Current Regulations

The proposed regulations introduce significant changes by replacing the outdated industry classification system with a more current standard.

Current System: Under existing regulations (26 CFR 1.132-4(a)(2)(i)), an employer’s line of business is determined by reference to the Enterprise Standard Industrial Classification Manual (ESIC Manual), prepared by the Statistical Policy Division of the U.S. Office of Management and Budget (OMB). An employer is considered to have more than one line of business if it offers property or services in more than one two-digit code classification referred to in the ESIC Manual. Examples of these two-digit classifications include general retail merchandise stores, hotels, auto repair services, and food stores. The ESIC Manual, a supplement to the Standard Industrial Classification (SIC), was last updated in 1974. The Treasury and the IRS adopted the ESIC Manual in 1989 based on a suggestion in the House Report on the Deficit Reduction Act of 1984, Public Law 98-369, 98 Stat. 494, which added Section 132 to the Code.
Proposed System: The proposed regulations would replace the ESIC Manual with the North American Industry Classification System (NAICS). The NAICS is the most current classification system in the United States, having been most recently updated in 2022, and is regularly revised every five years to keep pace with economic changes. This shift is deemed necessary because the ESIC Manual does not account for many current industries that did not exist in 1974, such as internet service providers, cell phone manufacturers, and smartphone application designers. The NAICS structure is a hierarchical six-digit coding system.
- For purposes of these proposed regulations, an employer’s line of business would be determined by reference to the NAICS four-digit "Industry Group" classification. An employer would be considered to have more than one line of business if it offers property or services in more than one four-digit NAICS industry group classification. Examples of such four-digit NAICS industry groups include General Merchandise Stores (including Warehouse Clubs and Supercenters), Traveler Accommodation, Automotive Repair and Maintenance, and Grocery Stores. While the five-digit NAICS industry classification is typically applied to a single-location establishment’s primary activity, the four-digit industry group was chosen to accommodate situations where an establishment might encompass more than one NAICS industry.
- Aggregation Rules: The existing aggregation rules under 26 CFR 1.132-4(a)(3) would continue to apply, with minor modifications to align with the NAICS. Significantly, the aggregation rule under 26 CFR 1.132-4(a)(3)(iii) would be amended. Currently, this rule allows retail operations on the same premises to be treated as one line of business if they would be considered one line of business if the merchandise were offered for sale at a "department store". The proposed regulations would replace "department store" with "general merchandise store, including warehouse clubs and super centers". This update reflects the prevalence of modern retail formats that offer a wide variety of merchandise but are classified under a single NAICS industry group (e.g., NAICS 4552 for Warehouse Clubs, Supercenters, and Other General Merchandise Retailers under the 2022 NAICS). This amendment aims to ensure equitable treatment for employees of other employers who sell a variety of merchandise, even if classified under multiple NAICS industry groups (e.g., a coffee shop also selling small kitchen appliances), provided the merchandise would constitute one line of business if sold at a general merchandise store, warehouse club, or super center. The proposed regulations also provide updated examples reflecting the use of NAICS classifications.

Examples Found in the Proposed Regulations

The proposed regulations provide several examples that reflect the use of the North American Industry Classification System (NAICS) classifications.

Specifically, the proposed regulations include:

General Examples of Four-Digit NAICS Industry Groups: The proposed regulations list examples of the four-digit NAICS industry group classifications that would determine an employer’s line of business under the new system. These include:
- General Merchandise Stores, including Warehouse Clubs and Supercenters
- Traveler Accommodation
- Automotive Repair and Maintenance
- Grocery Stores
Updated Examples for Aggregation Rules: The proposed regulations also provide updated examples for the application of the aggregation rules, which now align with the NAICS classifications.
- Aggregation Rule under § 1.132-4(a)(3)(ii) (Substantial Services Across Lines of Business): An example illustrates this rule with an employer operating a delicatessen (a specialty food store) and an attached service counter where food is sold for on-premises consumption (a restaurant or eating place). If most, but not all, employees work at both the delicatessen and the service counter, these separate operations would be treated as one line of business for fringe benefit purposes. This demonstrates how entities that might traditionally fall under different classifications are aggregated when employees significantly overlap their services.
- Aggregation Rule under § 1.132-4(a)(3)(iii) (Retail Operations on Same Premises): An example is given where an employer sells both specialty foods (e.g., specialty food retailers) and small kitchen appliances (e.g., electronics and appliance retailers) on the same premises. Under the proposed amendment, if these types of merchandise, when offered for sale together at a "general merchandise store, including a warehouse club or super center," would be considered within one line of business, then these separate operations on the same premises are treated as one line of business for the employer. This example specifically references how various merchandise, even if classified under two or more NAICS industry groups (such as "specialty food retailers" and "electronics and appliance retailers"), can be aggregated if they resemble the offerings of a modern "general merchandise store" (e.g., NAICS 4552 for Warehouse Clubs, Supercenters, and Other General Merchandise Retailers under the 2022 NAICS), which sells a wide variety of goods.

Reliance Prior to Final Regulations

The document containing these provisions is a notice of proposed rulemaking. The proposed regulations state that they "would replace a business classification system" and "would amend the Income Tax Regulations". However, the proposed regulations do not contain any provision that allows employers or employees to rely on these proposed rules prior to their finalization. Tax professionals should be aware that proposed regulations are not binding precedent and may be modified before becoming final.

Proposed Effective Date

The proposed regulations specify that they are proposed to be effective on the date these rules are published in the Federal Register as final regulations and would apply to taxable years beginning on or after that date.

The Treasury Department and the IRS are inviting comments on all aspects of the proposed rules, including the use of the NAICS four-digit industry group code, any necessary additional changes to the aggregation rules, potential challenges with the applicability date, and whether transition rules are needed. Comments and requests for a public hearing must be received by 90 days after publication in the Federal Register.

Prepared with assistance from NotebookLM.