ALERT - Employers Beware of Cell Phone IRS Audit Trap

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August 6, 2008

Many employers and employees may be surprised to learn that employer-provided cell phones are subject to stringent recordkeeping requirements. Unless personal and business use are differentiated, the IRS will treat an employee’s use of a cell phone as taxable income and the employer may not deduct the cell phone costs. The IRS is aggressively auditing this issue and the result is that large employers are being hit with significant tax adjustments. Although legislation has been introduced in both the House and Senate to repeal the burdensome recordkeeping, until it is passed, employers must maintain relevant records or face substantial tax liabilities.

Background

Cell phone and mobile communication devices are now a staple of daily business practice, where employers give employees cell phones and PDAs to keep them connected 24 hours a day, seven days a week.

Under Section 280F(d)(4) of the Tax Code, cell phones are defined as “listed property,” which means that detailed documentation is required for cell phones to benefit from accelerated depreciation and not be treated as taxable income to the employee. This documentation must substantiate that the cell phone is used for business purposes more then 50 percent of the time. Generally, “listed property” is property that inherently lends itself to personal use and is of substantial value, such as automobiles. The allocation between business and personal use is determined by dividing the number of hours the cell phone is used for business purposes during the year by the total number of hours that the cell phone is used during the year. The value of personal use is included in employee income and subject to withholding. A log listing every call, time, and purpose must be kept for the cost of the cell phone to be deductible.

When this law was passed in 1989, cell phones were viewed as an executive perk or luxury item. Now that they are a mainstream communication tool, the requirement to keep a log listing all cell phone calls is impracticable at best. Nevertheless, the IRS is aggressively enforcing this recordkeeping requirement. The agency recently reminded field examiners of the substantiation rules for cell phones as “listed property” with its publication “Audit Techniques Guide on Executive Compensation and Fringe Benefits.” Because cell phones are treated as listed property, under Section 280F, an employer must report the value of cell phone as income on an employee’s W2 unless the employee satisfies onerous substantiation rules. Employers caught in an audit without cell phone logs face additional taxes and penalties. For example, recent newspaper reports indicate that UCLA and the University of California, San Diego were hit with audit adjustments of $239,196 and $186,471, when auditors found that employees with cell phones were not keeping logs.

Pending Legislation

Legislation was recently introduced in both the House and the Senate to remove cell phones and similar telecommunications equipment from the category of “listed property,” effective beginning tax years after 2007. See H.R. 5450 MOBILE Cell Phone Act of 2008 and S. 2668.

Proponents of the bill explain that the strict substantiation requirements burden the business use of cell phones, dampen the growth of advanced technology, and are impractical, given the frequent use of cell phones and PDAs in a fast-paced global work environment.  Additionally, supporters argue that an employee’s use of an office phone does not require such documentation and therefore, cell phones should not be subjected to stricter substantiation requirements. Lastly, present IRS tax law has not kept pace with modern technology, as cell phones are no longer a luxury item, but a necessity.