The fringe benefit rules applicable to protecting executives

Heightened concern about the personal safety of employees following the events of September 11 has caused many employers to reexamine their corporate security policies. Realizing that security in the United States must be enhanced to deal with domestic terrorism, corporate executives are now more open to accepting the full range of protective measures determined to be necessary by security professionals. In conjunction with upgrading their security programs, employers may want to consider developing an "overall security program" that qualifies for the special valuation rules in the working condition fringe benefit regulations. This article reviews the tax requirements applicable to employees of non-governmental employers when using employer-provided transportation for security reasons. If the employer's security program meets these requirements, the value of any additional security protection provided to transport those employees, with respect to whom a bona fide business-oriented security concern exists, may be excluded from income under section 132(d) of the Internal Revenue Code. Moreover, a special safe harbor rule for valuing flights on the corporate aircraft for security concerns permits the employer to value any personal flights at a rate that is generally more favorable than the rate provided under the rules used by companies to value flights on noncommercial aircraft.

I. Overview of the Transportation-Related Security Rules

The working condition fringe benefit regulations permit employers to exclude from income a significant portion of the value of security protection provided to employees, when transporting them for personal purposes in company cars or on corporate aircraft. To take advantage of these rules, the non-governmental employer must prove that:

* a "bona fide business-oriented security concern" with respect to the employee existed at the time the security protection was provided; and

* if security protection is provided on a less-than-24hour basis to the employee, the employer has obtained and consistently complied with the recommendations of a study prepared by an independent security consultant, who objectively and reasonably assessed the type of security protection needed in each particular case.

A "bona fide business-oriented security concern" exists only if the facts and circumstances establish a specific basis for concern regarding the employee's safety. The examples given by the regulations are: (1) threats of death or kidnapping of, or serious bodily harm to, the employee receiving the protection or to a "similarly situated employee," or (2) a recent history of violent terrorist activity (such as bombings) in the geographic area in which the transportation is provided. In other words, the regulations contemplate a bona fide business-oriented security concern arising from specific threats to the employee's or a similarly situated employee's safety, as well as from the known existence of terrorist activity in the area in which the employee travels. Even though the World Trade Center was bombed in 1993, before the events of September 11, most Americans did not view the threat of terrorism as a significant risk factor to consider when traveling within the United States. Certainly, the IRS did not consider it to be the primary risk that employers would have to worry about.

II. Establishment of an Overall Security Program

Even if the employer is able to demonstrate a factual basis for concern regarding the employee's safety, no bona fide business-oriented security concern will be deemed to exist unless the employer is also able to demonstrate that an "overall security program" has been provided to protect the employee. This can be accomplished by either protecting the employee on a 24-hour basis or by providing security pursuant to the recommendations of an "independent security study." Protection on a 24-hour basis means that that employee must be protected while at home and work and while traveling for both business and personal reasons (including commuting). The bodyguard/chauffeur must be trained in evasive driving techniques and the car must be specifically equipped with security devices. Access to both the employee's home and the workplace must be controlled through the use of guards, metal detectors, alarms, or similar devices. Finally, in appropriate cases, air travel should be on the corporate aircraft for both business and personal purposes.

A. Independent Security Study

Because most executives reject the notion of living with 24-hour protection, the implementation of an "independent security study" is usually the more viable alternative. To qualify as such a study, the following conditions must be satisfied:

1. The security study must be performed with respect to the employer and employee (or a similarly situated employee of the employer) by an independent security consultant.

2. The security study must be based on an objective assessment of all the facts and circumstances.

3. The security study must recommend that 24-hour protection of the employee is not necessary and the recommendation must be reasonable under the circumstances.

4. The employer must apply the recommendations contained in the study to the employee on a consistent basis.

The regulations do not give specifics on how an independent consultant should go about evaluating the employee's need for security. The IRS has not issued any other guidance on the security exclusion rules, not even in the form of private letter rulings or technical advice memoranda, which could provide any insight into what the IRS might view as a sufficient evaluation. Before September 11, the IRS was adamant, in informal conversations, that there must be concrete proof of specific personal threats against the executive receiving protection. Thus, whenever possible, references to specific threats that may have been received either by the executive who is the subject of the study, or by similarly situated employees, should be included in the study, because the regulations warn that a "generalized concern for an employee's security" is not a bona fide security concern.

In addition, by analogy to the special rule permitting government employers to conduct their own internal security studies in lieu of having to hire an independent security consultant, any security study prepared for a private sector employer should include "an estimate of the length of time during which protection will be necessary." In any event, an independent security study should include the following elements:

* A discussion of any specific personal threats against the executives covered by the study, or any similarly situated employees.

* A discussion of the more general business-oriented security concerns facing the company's executives.

For example, given the recent terrorist attacks, the study may emphasize the increased danger that high-profile individuals, particularly executives of multinational companies, face when traveling at home and abroad. Likewise, the safety concern may be industry-specific, such as in the case of a manufacturer that has recently experienced a reduction-in-force or the closing of a facility, which could result in threats from disgruntled former employees.

* A discussion of the methods used by the security consultant to analyze the existence of security concerns for purposes of making recommendations.

   For example, the security consultant should interview each executive and
   survey his or her residence to assess the level of current security and the
   enhancements needed. In addition, the security consultant should survey the
   corporate offices and the executive suite. If there is a corporate
   aircraft, the security consultant should assess the level of 24-hour
   security at the hangar where the aircraft is kept.

* A discussion of the role of corporate security personnel in monitoring the protection of the covered executives.

* Recommendations for improving the company's current security protection of the executives covered by the study or similarly situated employees.

   For example, the study may recommend that a chauffeur trained in evasive
   driving techniques be used to drive the executives between their residences
   and regular places of business. The study may provide recommendations
   concerning the enhancement of both home and workplace security. The study
   may also conclude that the executives should travel by corporate jet,
   whenever possible, and that personnel should be hired to guard the
   aircraft, particularly whenever it is grounded in a foreign country.
   Likewise, the study may recommend that procedures be implemented for
   clearing all travel itineraries through the corporate security department,
   so that security personnel can provide travel advisory services in advance
   and make arrangements for additional ground security at the destination.

* A recommendation that 24-hour protection of the executive is not warranted given the current security threat and protective measures to be implemented.

B. Application of the Security Study

With respect to any executive who receives security protection on a 24-hour basis, the security-protection exclusion is not contingent upon a security study prepared by an independent outside consultant. If the application of the security protection exclusion depends upon a security study prepared by an independent consultant, however, the regulations require "the employer [to] appl[y] the specific security recommendations contained in the security study to the employee on a consistent basis." In addition, companies should request periodic updates of their security studies, especially when the affected executives change their work sites or residences, or both. Moreover, whether or not a new study is periodically obtained, each employer is required to "periodically evaluate the situation for purposes of determining whether the bona fide business-oriented security concern still exists." Thus, any employer maintaining an overall security program should set a schedule for reviewing whether the recommendations are being followed and for reevaluating the level of risk.

III. Valuation of Personal Travel A. Cars and Chauffeurs

When the regulatory requirements for demonstrating a bona fide business-oriented security concern have been met, the value of "transportation-related security" may be excluded from the employee's gross income as a working condition fringe benefit if, but for the bona fide business-oriented security concern, the employer would not have adopted such security measures. This does not mean that a primarily personal trip of the employee will be converted into an excludable fringe benefit. As explained by the regulations, only the value of the added security measures will qualify for exclusion as a working condition fringe benefit:

   For example, if an employer provides an employee with a vehicle for
   commuting and, because of bona fide business-oriented security concerns,
   the vehicle is specially designed for security, then the employee may
   exclude from gross income the value of the special security design [e.g.,
   bulletproof glass] as a .working condition fringe. The employee may not
   exclude the value of the commuting from income as a working condition
   fringe because commuting is a nondeductible personal expense.

Thus, the value of any personal use of an employer--provided vehicle must still be included in the employee's gross income and treated as wages (and subjected to payroll taxes). For example, if the employer is valuing the personal use of the car using one of the special valuation rules, such as the Automobile Lease Valuation rule, that calculation is not affected by the value of any security features added to the car pursuant to an overall security study, because the value of the personal use of the car must still be included in the employee's income.

Likewise, in addition to being able to exclude from income the incremental value of the vehicle attributable to bulletproof glass or other security features, the employee will be able to exclude the entire value of the services of the "bodyguard/chauffeur" from his income. However, the "bodyguard/chauffeur" must also be trained in evasive driving techniques.

B. Corporate Aircraft

1. Safe harbor valuation rule for "control employees. If the security study recommends that the covered executives use the corporate aircraft for both business and personal purposes, the employer is permitted to exclude the excess value, if any, of any personal trip computed under the noncommercial flight rule of Treas. Reg. [section] 1.61-21(g) over the value computed under the special safe harbor valuation rule for flights required because of bona fide business-oriented security concerns. Specifically, the value of the safe harbor airfare is determined under the noncommercial flight valuation rule by multiplying 200percent times the applicable cents-per-mile rates (commonly referred to as the Standard Industry Fare Level (SIFL) rates) by the number of statute miles in the flight and then adding the applicable terminal charge. In virtually every instance involving the use of corporate jets, this working condition fringe safe harbor for security-related travel reduces the valuation of personal trips on the corporate jet from 400 percent of the SIFL rates to 200 percent. This is because the aircraft multiples of the noncommercial flight valuation rule (e.g., 400 percent of the SIFL rates) are based on the maximum certified takeoff weight of an aircraft. The multiples vary according to whether the employee is a "control" or "non-control" employee. Because most corporate jets have a maximum takeoff weight of 25,001 pounds or more and the executives are considered to be "control" employees for purposes of these rules, the aircraft multiple is usually 400 percent of the SIFL rates. Thus, when a personal flight on the corporate aircraft is provided for security reasons, the flight may be valued at the lower aircraft multiple of 200 percent, resulting in a significant savings in employment taxes. Not only is a lower value included in the executive's wages for employment tax purposes, the lower value may be used for SEC reporting purposes.

2. Valuation of Flights by Family Members. Equally favorable is the valuation rule for personal flights by family members traveling with the executive. If a bona fide business-oriented security concern exists with respect to an employee, the concern is deemed to exist with respect to the employee's spouse and dependents when they fly with the employee. Therefore, their personal flights may be valued at 200 percent of the SIFL rates under the safe harbor valuation rule described above.

If the spouse and dependent children of an employee covered by an independent security study travel on the corporate aircraft without the executive, however, a separate security threat must be shown and a separate independent security study must be obtained concerning the family members, in order for their trips to be valued at the lowest (200 percent of the SIFL) rate. If a separate security study is not obtained, personal trips by any family member flying separately from the executive must be valued using the special valuation rules generally applicable to such flights under the regulations, i.e., the 400 percent of SIFL rate.

C. Risks Associated with Incorrect Use of Transportation-Related Security Rules

The IRS has never issued any guidance on the issue of what "penalty" would apply if it were successful in challenging the existence of a bona fide business-oriented concern or it prevailed in its assertion that the recommendations of the security study were not applied consistently to the covered employees. The fringe benefit regulations provide that, if a special valuation rule is not properly applied to a fringe benefit (or if part or all of the value of a flight is incorrectly excluded from income as a working condition fringe), the value of the fringe benefit may not be determined by reference to any value calculated under any special valuation rule in the regulations, but must be determined pursuant to general valuation rules, i.e., fair market value. In other words, the fringe benefit must be valued by the amount that an individual would have to pay for the particular fringe benefit in an arm's--length transaction. Specifically, the value of a flight on an employer--provided aircraft would have to be determined by the cost to charter a comparable aircraft.

In any case where the IRS challenges the employer's use of the transportation-related security rules, it is likely to argue not only that the special safe harbor rule for security protection in Treas. Reg. [section] 1.132-5(m) was used incorrectly, but that the underlying special valuation rule for noncommercial flights in Treas. Reg. [section] 1.61-21(g) was used incorrectly. In other words, the IRS will attempt to impose employment taxes on the difference between the charter value of the personal flights and the value determined by the employer using the safe harbor based on 200percent of the SIFL rates. Even if the IRS were successful in proving that the employer incorrectly excluded a portion of the value of personal flights under the safe harbor rule for security protection, the employer should be able to assert that it made a "good faith mistake" in determining that there were bona-fide business oriented security concerns. Evidence of the employer's good faith would be based on the fact that security study prepared by an independent consultant indicated that such concerns did in fact exist. Accordingly, assuming there is also evidence supporting the employer's good faith efforts to apply the recommendations in the study on a consistent basis, an argument exists that the maximum exposure to the employer, in the face of a challenge by the IRS, should be limited to the employment taxes on the difference in value for the flights computed using the 400-percent of the SIFL rates (the value that would have ordinarily applied under the noncommercial flight valuation rule of Treas. Reg. [section] 1.61-21(g)) and the 200-percent of the SIFL rates. In addition, the employer would be liable for the employment taxes on the increased incremental value of any additional security measures provided in conjunction with ground transportation.

IV. Non-Transportation Benefits

Although the final fringe benefit regulations, effective in 1989, require the use of home and workplace security measures in conjunction with 24-hour security, the regulations do not specifically provide that home security systems (or even workplace security measures or bodyguards) are excludable as "working condition fringes" when such measures are recommended by an independent security study. The focus of the regulations is on the exclusion to vehicles, aircraft, and other "transportation--related security." The pre-1989 temporary fringe benefit regulations, by contrast, stated that if a reasonable security study is adopted, "the value of security [impliedly, all security measures] provided pursuant to [such] a security study ... may be excluded from income...." This is consistent with the legislative history, which explains that the security-protection exclusion was designed to cover any safety precautions provided by the employer that would be considered ordinary and necessary business expenses. Both the temporary and final regulations warn, however, that "no exclusion from income applies to security provided by the employer that is not recommended in the security study."

Even though the final regulations do not contain explanations of the application of security protections other than transportation-related security, it is logical to assume that home security systems should be excludable as working condition fringes during the period that protection of the employee is recommended by the independent security study, because of the existence of a bona fide business-oriented security concern. If the executive is allowed to keep any home burglar alarm system or other security devices after termination of the security threat (or, if earlier, after termination of employment), however, it would be advisable to include the fair market value of the system in the employee's wages at that time.

V. Conclusion

The application of the transportation--related security rules, particularly with respect to travel on corporate aircraft, can drastically reduce the amount of income that executives must recognize in the case of employer-provided travel benefits. To take advantage of these rules, the non-governmental employer must demonstrate the existence of bona fide business-oriented security concerns with respect to the employees being protected and the implementation and consistent application of an overall security program to protect them. In light of recent events, employers are justified in being concerned about the risk that terrorist activities could pose to the safety of their employees and in establishing appropriate security programs that take such concerns into consideration. The rules discussed in this article are illustrated in the accompanying chart.

(1) See generally Treasury Regulation [section] 1.132-5(m) (cited throughout this article as "Treas. Reg. [section]--").

(2) The term "employee" for this purpose includes common law and statutory employees, directors, independent contractors, and partners of partnerships. Treas. Reg. [section] 1.132-1(b)(2).

(3) Treas. Reg. [section] 1.132-5(m)(2). In 1992, the security protection rules were amended to permit government employers providing less than 24-hour protection of their employees to prove the existence of an overall security program with a security study conducted by personnel expressly designated by the government employer, as opposed to having to hire an outside consultant. No correlative change was made in the rules applicable to private-sector employers. See Treasury Decision 8457, 57 Fed. Reg. 62192 (Dec. 30, 1992).

(4) Treas. Reg. [section] 1.132-5(m)(2)(i). The security exclusion is available for either in-kind employer-provided security protection or cash reimbursements for the cost of such protection, provided that in the case of a cash reimbursement the employee verifies that the payment is actually used to purchase security protection, and any unused portion of the advance is returned to the employer. See Treas. Reg. [section] 1.132-5(a)(1)(v).

(5) Treas. Reg. [section] 1.132-5(m)(2)(ii).

(6) Treas. Reg. [section] 1.132-5(m)(2)(iii).

(7) Treas. Reg. [section] 1.132-5(m)(2)(iv).

(8) Treas. Reg. [section] 1.132-5(m)(2)(i).

(9) Treas. Reg. [section] 1.132-5(m)(2)(v)(B).

(10) Treas. Reg. [section] 1.132-5(m)(2)(iv)(D).

(11) Treas. Reg. [section] 1.132-5(m)(2)(i), as amended by Treasury Decision 8457.

(12) Treas. Reg. [section] 1.132-5(m)(1).

(13) Treas. Reg. [section] 1.61.-21(d). Under the Automobile Lease Valuation rule, the employee would be taxable only on (a) his percentage of the personal use of the vehicle times the "Annual Lease Value" of the vehicle determined under the special tables in Treas. Reg. [section] 1.61-21(d)(2)(iii), plus (b) the fair market value of any employer-provided gasoline for all personal miles driven (or ridden) in the vehicle.

(14) Treas. Reg. [section] 1.132-5(m)(5).

(15) Treas. Reg. [section] 1.132-5(m)(4).

(16) Treas. Reg. [section] 1.61-21(g)(7).

(17) Treas. Reg. [section] 1.61-21(g)(8)(i).

(18) See 17 C.F.R. [section] 229.402, for the SEC disclosure rules pertaining to executive compensation, including noncash fringe benefits.

(19) Treas. Reg. [section] 1.132-5(m)(3)(i) and (ii).

(20) Treas. Reg. [section] 1.132-5(m)(3)(iii).

(21) See Treas. Reg. [section] 1.61-21(c)(5) and 1.61-21(g)(13)(ii).

(22) Treas. Reg. [section] 1.61-21(b). In Technical Advice Memorandum 9801002 (Sept. 3, 1997), the IRS relied on the regulation to rule that a car dealership was not entitled to use the Automobile Lease Valuation rule in Treas. Reg. [section] 1.61-21(d) for purposes of valuing the personal use of vehicles provided to employees, because the dealer had used an unauthorized method in valuing the vehicles. Consequently, the IRS assessed employment taxes on unreported income and wages based on the fair market value of the benefits. Likewise, in BMW of North America, Inc. v. United States, 39 F. Supp.2d 445 (D.N.J. 1998), the court held that Treas. Reg. [section] 1.61-21(c)(5) was a penalty provision that applied when the taxpayer had used an incorrect valuation method to value the use of BMWs provided to employees of a dealership. Although TAM 9801002 and BMW of North America deal with the car valuation rules, it is likely that the IRS, in any case in which it determined the SIFL rules were misused for valuing personal flights, would insist that the "charter rates" should apply to value personal use of that corporate aircraft by all the executives (including not only the executives whose flights are shown to have been misvalued, but all other employees who have used the aircraft).

(23) The fringe benefit valuation regulations were modified in 1992 to permit employers to use the special valuation rules, even if the special valuation rules were not used correctly within the deadlines for filing information returns or the employees' individual federal income tax returns. Treas. Reg. [section] 1.61-21(c)(3)(ii). The special rules may be used, provided (a) the employee is not a "control employee" or (b) the employer made a good-faith mistake in valuing the employee's benefit.

(24) In addition, the IRS would likely allege that the employer should lose a deduction for the allocable part of depreciation expense, crew expense, fuel, and other operating costs related to all allegedly misvalued personal flights of the aircraft, on grounds that the exception to the deduction disallowance rule of section 274(a) of the Code, which is provided in section 274(e)(2), is not available, because the employer did not properly impute the charter value as income to the travelling employees. In making these arguments, the IRS would distinguish Sutherland Lumber-Southwest, Inc. v. Commissioner, 114 T.C. 197 (2000), aff'd, 255 F.3d 495 (8th Cir. 2001), in which the Tax Court held that there is no deduction disallowance under section 274 if the SIFL value is properly used and reported to the employee, because, under the valuation regulations cited above, the "proper value" was not, in fact, imputed.

(25) See Treas. Reg. [section] 1.132-5(m)(2)(iv).

(26) See Treas. Reg. [section] 1.132-5T(m)(2)(iv).

(27) H. Rep. No. 98-432, Part 2, 98th Cong., 2d Sess. 1602 (1984). This concept is related to the rule allowing a deduction under section 162 (and therefore an exclusion under section 132(d)) for the cost of meals, entertainment and similar personal items, which are not incurred while on business travel away from home overnight, but are nevertheless clearly shown to be "different from or in excess of that which would have been [spent] for the taxpayer's personal expense." See Sutter v. Commissioner, 21 T.C. 170 (1953), acq. 1954-1 C.B. 6; and Technical Advice Memorandum 80006004 (Oct. 26, 1979).

MARIANNA G. DYSON is a partner with Baker & McKenzie in Washington, D.C. She formerly served as Special Assistant for Fringe Benefits in the IRS Office of Associate Chief Counsel (EB/EO). She is a graduate of the University of Louisville and Georgetown University Law Center. She expresses her appreciation to Thomas M. Cryan, Jr., an associate with Baker & McKenzie, for his assistance in the preparation of this article.

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