Commuting Disallowance in 274(l) Does Not Apply to Partners, 2% Shareholders in S Corporations

Beginning in 2018, Internal Revenue Code (I.R.C.) Section 274(l) disallows deductions for the cost of flights provided to an "employee" for commuting. While this deduction disallowance may apply to employees of Subchapter C corporations, it should not apply to flights provided by partnerships to partners or to flights provided by Subchapter S corporations to 2-percent shareholders. Partners in partnerships and 2-percent shareholders in Subchapter S corporations are not "employees" subject to the commuting deduction disallowance.

For this purpose, "employee" is defined in Treasury Regulation § 1.274-14 as follows:

[E]mployee means an employee of the taxpayer as defined in [I.R.C.] section 3121(d)(1) and (2) (that is, officers of a corporate taxpayer and employees of the taxpayer under the common law rules).

Under § 3121(d)(1), "employee" does not include a partner in a partnership. Rev. Rul. 69-184, 1969-1 C.B. 256 ("Bona fide members of a partnership are not employees of the partnership ..."); Chief Coun. Adv. 2001-17-003 (April 30, 2001) ("Bona fide members of a partnership cannot be employees ...").

The term "employee" under § 274(l)(1) also does not include 2-percent shareholders of Subchapter S corporations. Under § 1372, such shareholders are not employees for fringe benefit purposes for income tax purposes. In this regard, § 1372(a) provides:

For purposes of applying the provisions of this subtitle [Subtitle A – Income Taxes] which relate to employee fringe benefits–

(1) the S corporation shall be treated as a partnership, and

(2) any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership.

Commuting flights provided to an employee are fringe benefits. Section 274(l), which disallows the costs of commuting flights, clearly relates to employee fringe benefits. Accordingly, under the plain language of § 1372(a), 2-percent shareholders of S corporations are treated as partners for purposes of the commuting disallowance in § 274(l). Since partners are not employees subject to § 274(l), 2-percent shareholders of S corporations are likewise not subject to § 274(l).

The IRS has applied this analysis of § 1372 in Chief Counsel Advice 2003-44-008 (July 1, 2003). In that Chief Counsel Advice, the IRS explained that 2-percent shareholders of S corporations are not "employees" subject to the entertainment disallowance provisions in § 274(e)(2). Section 274(e)(2) applies the entertainment disallowance to entertainment provided to an "employee." Applying § 1372(a), the IRS concluded that a 2-percent shareholder of an S corporation was not an "employee." Therefore, the IRS concluded that the entertainment provided to the 2-percent shareholder of an S corporation was governed by § 274(e)(9), which applies to a recipient of entertainment who is "not an employee."

In this regard, the Chief Counsel Advice explained its reasoning as follows:

Entertainment expenses that are included in an employee's income are excepted from § 274(a) disallowance. Section 274(e)(2) excepts:

Expenses for goods, services, and facilities, to the extent that the expenses are treated by the taxpayer, with respect to the recipient of the entertainment, amusement, or recreation, as compensation to an employee on the taxpayer's return of tax under this chapter and as wages to such employee for purposes of chapter 24 (relating to withholding of income tax at source on wages). [Emphasis added.]

Section 1372 provides that a 2% or greater S corporation shareholder is treated as a partner and the S corporation is treated as a partnership for purposes of applying the employee fringe benefit rules. Section 1.707-1(c) provides that a partner receiving compensation for services performed for the partnership is treated as a person who is not a partner. The partner must include the compensation as income under § 61(a) and the partnership may deduct the compensation under § 162(a), but the partner is not regarded as an employee of the partnership.

Costs of entertaining the shareholders of an S Corporation are similarly excepted from the disallowance by § 274(e)(9), if the S Corporation reports the value of the benefit to the shareholder on the S Corporation's information return (and shareholder payee statement).

Congress made § 274(e)(9) permanent in the Miscellaneous Revenue Act of 1980, Pub. L. No. 96-605. Congress intended that a rule similar to § 274(e)(2) should apply to "facilities" (fringe benefits) "provided to nonemployees" so long as there was income inclusion and information reporting. H. Rep. No. 1278, 96th Cong. 2d Sess., reprinted in 1980-2 C.B. page 4709, 719.

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The benefits to the shareholders in this case are governed by § 274(e)(9) rather than section 274(e)(2) which applies to employees.

Just as the IRS ruled in the Chief Counsel Advice that § 1372 requires that 2-percent shareholders in S corporations must be treated as partners and not as employees for purposes of the entertainment disallowance under § 274(e)(2) and (9), the same interpretation should apply to the term "employee" under § 274(l) as well. Section 1372 is statutory authority, and the IRS has no basis on which to ignore it.

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