Employee Expenses Incurred for the Benefit of the Company under Arrangement

by John Anthony Castro, J.D., LL.M.

Introduction

The conclusion of this article is that it is still legally permissible to deduct unreimbursed employee business expenses on IRS Form 2106 despite the new tax law changes applicable for tax year 2018. However, if you do this without our firm, you are exposing yourself to inevitable confrontation with the IRS coupled with tax penalties and interest. Our firm handles compliance in-house. Contact our firm for a free consultation.

Background

Section 62(a)(2)(A) as a whole reads: “For purposes of this Subtitle [Income Taxes], the term ‘adjusted gross income’ means, in the case of an individual, gross income minus the following deductions: The deductions allowed by part VI (section 161 and following) [Sections 161-199A] which consist of expenses paid or incurred by the taxpayer, in connection with the performance by him of services as an employee, under a reimbursement or other expenses allowance arrangement with his employer.”

The statute is focused solely on the payment of an expense by a taxpayer who himself is performing services as an employee during the existence of an arrangement. The statute makes absolutely no reference to a reimbursement being deductible. In fact, the statute makes no reference to an actual reimbursement at all. The statute only references the employee paying or incurring the expenses and the existence of a reimbursement arrangement. An arrangement can be formal or informal in accordance with the plain meaning of the term “arrangement.” The entirety of the statutory text is wholly void of any ambiguity. It is indisputably clear on its face: if the company has an expense reimbursement arrangement with an employee, any expenses paid by the taxpayer in the performance of services as an employee will be deductible by that employee.

However, the title of the section is “Reimbursed expenses of employees,” which the Internal Revenue Service and, indeed, the entire tax community contends implies that Congress intended an actual reimbursement requirement to permit the deduction. As such, Treasury has promulgated extensive regulations on that basis.

The legal questions, therefore, are (1) whether the statute is ambiguous, (2) to what extent regard, if any, should be given to the title of the section, and (3) the validity of regulations interpreting Section 62(a)(2)(A).

Ambiguity as a Prerequisite

The United States Supreme Court has held that although “it has long been established that the title of an Act ‘cannot enlarge or confer powers,’”[1] the title of a statute or section “can aid in resolving an ambiguity in the legislation’s text.”[2] As Chief Justice Marshall explained, “[w]here the mind labours to discover the design of the legislature, it seizes everything from which aid can be derived.”[3] A title or heading, however, being only “a short-hand reference to the general subject matter involved” and “not meant to take the place of the detailed provisions of the text,”[4] can provide only limited interpretive aid in situations involving ambiguity of the text. Thus, a heading may shed light on the section’s basic thrust,[5] or on ambiguous language in the text, but it “cannot limit the plain meaning of the text,”[6] and “has no power to give what the text of the statute takes away” or, vice-versa, to take away what the statute gives.[7]

As shown above, the statutory text is unambiguous on its face and provides taxpayers with a deduction for expenses paid in connection with the performance of services as an employee as long as it is done under a reimbursement arrangement with the employer. The title, however, purports to take that away by imposing the requirement of an actual reimbursement. In accordance with established principles of statutory interpretation as mandated by the U.S. Supreme Court, it is not appropriate to refer to the section title when the statutory text is unambiguous and clear on its face.

Therefore, Section 62(a)(2)(A) permits an employee to deduct expenses paid in connection with employment as long as there’s a reimbursement arrangement with the employer.

Validity of Regulations

The United States Supreme Court has also held that regulations promulgated by Treasury cannot “conflict with the plain meaning” of the statute.[8] As explained above, the only two requirements for a Section 62(a)(2)(A) deduction is the payment of an expense connected to employment and the existence of a reimbursement arrangement. Congress clarified in Section 62(c), however, that an arrangement would not be treated as a reimbursement arrangement within the meaning of Section 62(a)(2)(A) unless it required the employee to substantiate the expenses and did not allow the employee to retain any excess over the amount substantiated.[9]

What constitutes sufficient substantiation? Treasury regulations build upon that. Regulations require substantiation of the business connection and proof of the expense. For business connection, the only requirement is confirmation that the arrangement only provides reimbursements “for business expenses that are allowable as deductions by” Sections 161-199A. For substantiation, regulations effectively require itemizing each individual expense, identifying the specific type of expense like “hotel booking,” the broader category under which it falls like “travel,” the specific nature of each individual expense like “attending conference for tax planning,” and a specific description of its relation to the company’s business activities like “continuing legal education for licensing requirement,” which relates back to the business connection. In other words, avoid aggregating expenses into broad categories, using vague terms, and not being descriptive. These are all reasonable interpretations of the substantiation standard under Section 62(c).

Therefore, with regard to the regulatory provision discussed above, Treasury has properly exercised its regulation promulgating authority.[10]

Conclusion

This has gone unnoticed for far too long because Congress and the IRS believed the title of Section 62(a)(2)(A) would be given legal effect without understanding the judicial canons of statutory interpretation that prohibit reference to section titles absent ambiguity. While there is ambiguity regarding the substantiation standard of an arrangement, there is no ambiguity with regard to the ability to deduct expenses incurred during the existence of a reimbursement arrangement.

It is our firm’s position that, as long as a taxpayer pays expenses in connection with his employment and there exists an accountable reimbursement arrangement with the company that requires substantiation, an unreimbursed expense is deductible as an “above-the-line” deduction under Section 62(a)(2)(A).

As the Honorable Judge Joseph Connor held, “as long as the law allows deductions of ordinary and necessary expenses incurred in carrying on any trade or business, an employee should not be penalized in being precluded from the allowance of a deduction because his employer does not reimburse him.”[11]

We concur.

Closing

Contact our firm to schedule a free consultation. We handle annual tax compliance in-house. If you do this without our firm, you will get audited, and the IRS will impose penalties. You need to contact our firm.

Update (01/05/2021)

In December 2017, Congress passed a comprehensive tax reform bill. In that bill, they suspended miscellaneous itemized deductions for tax years 2018 through 2025. The consensus in the tax community was that this effectively abolished the deductibility of "unreimbursed employee expenses" since those had historically been considered "miscellaneous itemized deductions" since they supposedly were not covered by any other specific statutory provision.

The problem with that interpretation is that it was based on a pre-2012 approach to statutory interpretation. Prior to 2012, there was no uniform approach to statutory interpretation in the tax world. Can Treasury go beyond the plain meaning of the terms in the statute if logic supports their interpretation? The United States Supreme Court, in U.S. v. Home Concrete (discussed in more detail in this article) made it abundantly clear that the plain meaning of the terms in the statute is the "red line" that Treasury cannot pass. In that case, they argued that the term "omission" should logically include an overstatement of a basis that results in lower reported income; hence, income was omitted. The U.S. Supreme Court disagreed declaring that the plain meaning of the term "omission" is something left out whereas an overstatement of basis is something added in, which not only conflicts with the plain meaning of the term "omission" but is, in fact, the exact opposite.

Applying this now Supreme Court-mandated canon of statutory interpretation, the actual text of Section 62(a)(2)(A) appeared to no longer support the notion that it only referenced reimbursed expenses. The plain text made no reference to a reimbursement requirement. It appeared to only have two requirements: incurring an expense as an employee and the existence of a reimbursement arrangement.

However, based on additional research, we have concluded a third requirement: the taxpayer must subjectively believe that the expense is reimbursable pursuant to the understanding the taxpayer has with the employer.

We will be applying this interpretation for tax year 2020.

Please note that this does not mean any claimed expenses under the interpretation applied in 2018 and/or 2019 was an error or indefensible, it simply means our interpretation has evolved. We will continue to fully defend legal positions taken by our firm at no additional cost to clients and reimburse fees to the extent attributable to any legal positions our firm both took on a client's tax return and took into account in calculating the fee.

About the Author

John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English, an esteemed graduate of Georgetown University Law Center in Washington DC where he earned a Master of Laws in Taxation with Certification in International Taxation, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney widely renowned for his legal research and development of creative solutions to complex legal problems as well as his fierce advocacy for clients with offices in New York, Los Angeles, Washington DC, Miami, and Dallas.