Recent Tax Developments: Tax-exempt Employee Meals, Indebtness of S Corporations to Their Shareholders, and Unsecured Notes Contributed by Partners

October 17, 2014

IRS Scrutinizes Tax-exempt Employee Meals

Over the past several years, the IRS has conducted extensive employment-tax audits to combat tax avoidance. In particular, the IRS is scrutinizing the treatment of meals offered to employees by their employers, which are exempt from employment and payroll tax if provided to employees "for the convenience of the employer." Meals offered by companies can also qualify for tax-exempt status if employees "can't otherwise eat proper meals within a reasonable period of time." Companies that provide cafeterias for employees can deduct the full cost of the meals; such deductions are not subject to the 50 percent limit that typically applies to business meals.

The IRS has taken particular interest in corporate campuses with well-stocked cafeterias and office "pantries." Concerned that these companies have been exploiting the exemption for employee meals, the IRS has made the issue an administrative priority for the year. The IRS intends to promulgate new rules and provide additional guidance on employer-provided meals.

Ultimately, if the IRS decides that such meals are taxable, companies may have to consider selling meals to employees at cost and giving the employees taxable raises as compensation for this cost.

Final Regulations—Basis of Indebtedness of S Corporations to Their Shareholders

On July 22, 2014, the IRS released final regulations for determining the basis of indebtedness owed by S corporations to their shareholders. (T.D. 9682, 79 Fed. Reg. 42675-01 (July 23, 2014).) Abandoning the actual economic outlay test formally used to make these determinations, the final regulations provide that S corporation shareholders can increase their basis of indebtedness of the S Corporation to the shareholder only if the indebtedness is bona fide. The final regulations became effective on July 23, 2014. A shareholder's basis in amounts loaned to an S corporation is important because the amount of losses and deductions that pass through to a shareholder is generally limited by basis.

The actual economic outlay standard for determining basis of indebtedness of an S corporation to its shareholder required shareholders to be made "poorer in a material sense" in order for their bases of indebtedness to be increased. Under the final regulations, shareholders receive basis in indebtedness only if it is bona fide indebtedness of the S Corporation to the shareholder. Whether indebtedness is bona fide is determined under general federal tax principles and depends on the relevant facts and circumstances.

The final regulations retain the actual economic outlay standard with respect to guarantees; thus, S Corporation shareholders may increase their basis in indebtedness only to the extent that they actually perform under a guarantee.

Unsecured Notes Contributed by Partners Have No Basis

In VisionMonitor Software, LLC v. Commissioner, T.C. Memo. 2014-182, the Court held that partners had zero bases in the unsecured promissory notes that the partners had contributed to the partnership. Finding that the notes created only contractual obligations, the Court held that the contributions were not the equivalent of cash contributions, and without more, did not increase the partners' bases in their partnership interests. Thus, the partners' bases in their partnership interests would be increased only as payments on the promissory notes were made. The Court distinguished the case from Gefen v. Commissioner, 87 T.C. 1471 (1986), in which the partner assumed a third-party debt of the partnership in addition to agreeing to make additional contributions to the partnership, if needed. A partner's basis in his or her partnership interest is important, as it limits the ability of the partner to use losses and deductions passing though from a partnership and the amount of cash the partner can receive from the partnership, without paying tax on the distribution.