Satisfying the IRS: Incentive Travel Tax Laws

This article addresses the critical tax regulations regarding the use of incentive travel and meetings and was written with the assistance of James Gossett, an attorney for the Society of Incentive Travel Executives.

We all know that the tax code is a Byzantine mass of confusion. Until recently, though, the tax laws governing incentive travel awards have been relatively straightforward. Until 1986, that is. The Tax Reform Act of 1986 eliminated or substantially reduced many deductions and created new limitations on incentive travel. Quite a number of the new restrictions have since been made tougher by the IRS. And though many of the rules have been clarified by the IRS (the relevant Code Sections are 162 and 274) or tested through case law, making your way through the tax code is still a hair-pulling experience. The 12 questions in this article should help you make some sense of the rules and restrictions.

How is incentive travel different from meetings?

With "pure" incentive travel, as opposed to business travel for meetings and other purposes, the travel award is given as a prize for the accomplishment of set goals. The recipient is typically a customer, an employee, or an independent contractor or service provider. The goals to be achieved may take many forms, including sales quotas, purchase quotas, or improved performance standards.

For tax purposes, "pure" incentive travel is pleasure travel awarded for a business purpose. That means that the sponsoring or awarding company can deduct the cost of the award (what the business actually paid, regardless of fair market value), and the recipient of the award must report the fair market value of the award as income. It's true that the lines between business and pleasure get blurred all the time in incentive travel situations (we'll get to that later), but it's a good idea to begin with this characterization. Generally speaking, a meeting is an event that takes place primarily for the purposes of educating, motivating, and communicating, without any need for the recipients to perform. Although the guidelines are somewhat vague, meeting planners should make sure they have all of the documentation to prove that an event was indeed a meeting. That documentation can include agendas, programs, pre-meeting materials, etc.

What are the guidelines for "pure" incentive travel?

The crucial phrase in determining the deductibility of your incentive award is whether the program was "ordinary and necessary." However, there is no clear standard of "ordinary and necessary."

Generally, if the award program directly benefits the sponsoring company (by encouraging employees, customers, and suppliers to reach greater levels of performance), and the awards themselves are not outrageously lavish, the award program will pass the "smell" test and be deemed an "ordinary and necessary" business expense. There is a sense of quid pro quo in the necessary relationship between the recipient's level of service to the sponsoring company and the gift of a travel award: for example, a customer buys a certain amount of products or services and gets a long weekend in Aruba; a sales rep meets his sales quota and wins a trip to Hawaii. In these examples, the awards seem like necessary incentives and thus "ordinary and necessary" business expenses because they further the interests of the sponsor.

When is an award too lavish?

In addition to the need for a profitable business relationship between sponsor and recipient, the value of the award has to be in line with the value of the business benefit provided by the customer, employee, or supplier. The award of a $5,000 cruise for a customer's purchase of $200 worth of widgets would probably fall under the category of "lavish and extravagant" (or "unreasonable compensation" if you substitute an employee selling widgets for a customer buying them in the example). In either case, a red flag might go up at the IRS and they would most likely disallow the deduction.

If the IRS perceives that the primary purpose of the award was something other than the furthering of that business's interests, it will treat the award as a gift. The giver is limited to a deduction of $75 per recipient per year but the recipient does not have to report the award as income.

What records need to be kept?

The Treasury Department has clear "substantiation and documentation" guidelines, and while it isn't evident whether they must be followed to the letter in the case of incentive travel, let's just say it's not a bad idea. This is particularly true when the recipient is an employee.

Awarding companies should protect their deductions by maintaining an account book, diary, or statement of expense. In addition, they should retain any canceled checks, credit card slips, or hotel receipts. Records should reflect the amount of each expenditure, times and places of travel, the business purpose of each expenditure, and the recipient's business relationship to the awarding company.

What needs to be filed?

Another way for awarding companies to protect their deductions (and stay out of jail in the process) is to file the right paperwork on recipients. For customers and contractors/suppliers, that means reporting any award that exceeds $600 in value, provided the recipient is not a corporation. This is accomplished by filing a Form 1099 MISC, along with a Form 1096, by Feb. 28 of the calendar year following the year in which the award was made. When the recipient is an employee, the employer must declare the value of the award as compensation to the employee (as opposed to a travel expense), and as wages for the purposes of withholding. The proper form to use here is the W2.

Recipients should know that the full cash value of the award (including reimbursed expenses) will be counted as gross income, and should be entered on their 1040s. One notable exception to this general rule is that of a salesman granted an incentive travel award by his/her sales manager (not the employer business). In this case the value of the award must still be declared as income, but not as wages subject to withholding.

What if business and pleasure are mixed?

Another exception occurs with business travel. According to Jim Gossett, an attorney for the Society of Incentive Travel Executives, "When the trip is taken by the traveler for the purpose of business as opposed to pleasure, it is not a 'pure' incentive travel situation." When the trip is made for both reasons, then it is a matter of determining which purpose is dominant. When it's business, the expenses to and from the destination might not be counted as income, and may be deductible under certain conditions (see below); when it's pleasure, those expenses would be countable as income. Other expenses can be broken into either the primarily business or primarily pleasure categories and treated accordingly. When expenses are deemed necessary business expenses and are not reimbursed by the employer, the IRS throws in a caveat: An employee may deduct only the amount of their total business expenses for the year which exceeds 2 percent of his/her adjusted gross income. The amount of expenses that falls below the limit is non-deductible.

How about when employee expenses are reimbursed?

The "2 Percent Rule" makes it very important for employees to seek reimbursement using a plan that conforms to IRS guidelines. If the employer uses an "accountable reimbursement plan" (that's when the employee is required to substantiate, in a manner deemed appropriate by IRS Code 274, each expense to be reimbursed), then the reimbursed expenses are not counted as income, are not to be reported as wages on the employee's W2, and are not taxed.

When the employee does not substantiate his/her expenses (as part of a "non-accountable reimbursement plan"), then the reimbursed expenses are treated as income, must be reported as wages on the employee's W2, and are subject to income taxes. The employee can deduct these expenses as itemized miscellaneous deductions. However, these deductions will be subject to the "2 Percent Rule."

Are there restrictions on per diems and mileage?

Yes. When the award giver grants a per diem to the recipient, and/or agrees to reimburse for mileage, there are a few things to keep in mind. The 1986 Reform Act gave the Commissioner of the IRS the authority to establish standard mileage rates and per diem rates for business travel. If you don't follow the guidelines, you are still allowed to deduct your actual expenses, but you'd better substantiate the deductions down to the last tea bag, since deductions that exceed the guidelines are very likely to attract particular scrutiny. For information on per diems, look for updates in Code Section 274 and IRS Publication 463. Call 800-829-1040 and ask for these updates.

What about company personnel required on the trip?

When company personnel are required to accompany travel award recipients for all or part of the trip, that person's involvement is treated as a business trip, even if the trip is to a "pleasure" destination. But beware: The IRS loves to challenge these deductions.

What about when spouses share in the award?

If the spouse of a recipient is included in a "pure" incentive travel award, then the value of the award becomes part of the couple's income, and can likewise be fully deducted by the awarding company. However, when the trip is of a business nature for the recipient, and thus the cost may be non-taxable (as income) for the recipient, things become more complicated. The spouse's expenses then become non-deductible by the recipient unless he/she can prove that his/her participation served a "bona fide business purpose." In addition, the IRS has recently changed the rules to require that the spouse be an employee of the primary business traveler to claim deductions. Employees traveling with spouses on business should beware: The IRS has become bullish on spouse deductions.

Are there special restrictions for foreign travel?

When the trip meets the requirements for "pure incentive travel," treat foreign travel as you would any other incentive travel award. However, problems arise when the awarding company and/or the recipient try to characterize the trip as a meeting. Basically, the IRS does not allow business deductions for travel to conventions, seminars, or other meetings outside the "North American area" unless the parties can prove not only that the meeting on foreign soil was directly related to the conduct of his/her business, but that it was "as reasonable" that the meeting be held in that foreign destination.

"North American area" refers to the United States, Canada, Mexico and Puerto Rico, the U.S. Virgin Islands, American Samoa, Baker Island, Barbados, Bermuda, Costa Rica, Dominica, Dominican Republic, Grenada, Guam, Guyana, Honduras, Howland Island, Jamaica, Jarvis Island, Johnston Island, Kingman Reef, Marshall Islands, Micronesia, Midway Islands, Northern Mariana Islands, Palau, Palmyra, Saint Lucia, Trinidad and Tobago, and Wake Island.

What about cruises?

For "pure" incentive travel arrangements, cruises present no special problem. And business travel on cruise ships can be deductible, subject to general business travel rules. For conventions, seminars, and other meetings aboard ship, travel is deductible as long as the taxpayer establishes that 1) the meeting is directly related to the active conduct of his/her trade or business, 2) the ship is of U.S. registry and makes all of its ports of call in the U.S. or its possessions, and 3) the taxpayer attaches to his/her tax return-for the year in which the cruise was taken-two information statements containing a) the number of days of the trip, the number of hours in each day he/she devoted to business as well as a program of scheduled business activities conducted during the trip, and b) a signed statement by an officer of the sponsoring organization detailing the above information.

Additionally, the code limits the total deductibility of "luxury water transportation" for meetings to $2,000 per year total.

To obtain the IRS Code Sections and Publications mentioned in this article, call 800-829-1040 or go to http://www.irs.gov to review specific publications online. For questions, call SITE attorney Jim Gossett at 312-876-7833.