Article by James P. Sweeney, RSM US LLP
This information is provided for general educational purposes only. It should not be relied upon as, or in place of, professional advice. Readers are encouraged to work with their tax advisors when addressing specific issues.
Section 119 of the Internal Revenue Code provides for the potential exclusion of all or some of this benefit’s value from an employee’s taxable income, but only if one of two potential “tests” is met. The first test—for tax-free housing—is very difficult to pass. The second test—which caps an employee’s tax liability for housing—is easier to meet but usually not applied correctly.
As defined by the IRC, Section 119 broadly governs “meals or lodging furnished for the convenience of the employer.” The confusion around this section of the code can hardly be overstated: The IRS itself has lobbied Congress to change the section because of perceived and real marketplace misunderstandings, and last year the then-chair of the House Ways and Means Committee presented to Congress proposed legislation for widespread tax reform that included a revamp of Section 119.
Until such changes are enacted, independent schools must comply with the code to the best of their ability. This means including the value of housing benefits in employees’ gross income unless they can pass one of two tests, which we will call the Section 119(a) test and the Section 119(d) test.
The Section 119(a) Test: a High Fail Rate
Under Section 119(a), the value of lodging furnished to an employee (and, by extension, his or her spouse and dependents) by an employer may be excludable from the employee’s gross income if three (sub)tests are met:
- The lodging is furnished on the business premises of the employer.
- The lodging is furnished for the convenience of the employer.
- The employee is required to accept such lodging as a condition of employment.
Regarding the condition-of-employment requirement, the regulation further provides that the employee must be required to accept the lodging so that he or she may properly perform the duties of his or her employment. Thus, even if the employer requires the employee to accept the lodging, the employee may not exclude this benefit’s value unless the lodging proves necessary for him or her to properly do his or her job.
In actual court cases, an absence of all necessary facts has made the Section 119(a) test very difficult to pass.
For example, in applying the tests “for the convenience of the employer” and “condition of employment,” courts have held that they are essentially the same. Both tests require a “direct nexus” between the lodging furnished and the asserted business interests of the employer served. Schools have been most likely to fail to meet the “convenience” test when they attempt to invoke Section 119(a) for their heads of school.
Here’s a real-life example. Winchell v. United States involved a college president who lived on college-owned property four miles from the main campus. He maintained offices at his home and in the administration building on campus, and theoretically he was “on call” around the clock and occasionally summoned to campus after hours for various reasons. In addition, he performed certain services at home such as occasionally entertaining benefactors and dignitaries, hosting receptions, holding meetings and working on administrative matters.
The court concluded that the value of the residence furnished by the college to the president was not excludable from gross income, determining that neither of the tests had been met. With respect to the condition of employment test, the court specifically found that the nature of the president’s position did not realistically require him to be available for duty at all times. In addition, the court determined that the president on the whole performed relatively insubstantial services for the college at the home.
In addressing the convenience-of-the-employer test, the court concluded that although the college’s educational and fund-raising goals may have been collaterally served to some extent by the president’s home, there was an “insufficiently direct” relationship between the housing provided and the college’s educational interests.
In subsequent rulings, the IRS has followed the position set forth in this case; that is, school employees on call for infrequent emergency situations do not satisfy the test of being available for duty at all times.
Should a school fail to meet any of these three tests, it must include in an employee’s gross income the value of the lodging it furnishes to that employee. However, all is not lost, as a school has a second chance under the Section 119(d) test.
The Section 119(d) Test: a 5 Percent Safe Harbor
Added to the Internal Revenue Code in 1986, Section 119(d) applies specifically to educational institutions that own properties (“qualified campus lodging”) on or in proximity to their campus that they rent to employees. This is not an unusual situation for schools that do not have qualified housing on their premises and thus provide a nearby residence for the head of school.
Section 119(d) is based on the “inadequate rent calculation” and rests on comparisons between two numbers. Under certain scenarios, an employee may exclude from gross income the value of this housing. Under other scenarios, if the rent is determined to be “inadequate,” then the employee’s gross income includes all or a portion of the value of that housing.
The inadequate-rent calculation determines which scenario applies. If the rent is deemed adequate based on a fair-market valuation by a qualified appraiser, the employee does not include the value of the lodging in his or her income. For this to be the case, the rent paid must be equivalent to or greater than the lesser of either: 5 percent of the home’s appraised fair market value (the safe harbor amount), or the average rent that others pay to rent comparable properties owned by the institution.
But if the rent is deemed inadequate, the employee includes in gross income all or a portion of the value of the housing provided. To be inadequate, the rent paid must be either less than 5 percent of the appraised value or less than the average that others pay to rent comparable properties owned by the institution.
Hypothetical example: ABC Academy owns a residence near its campus that it rents to Jane Smith, head of school, for $500/month ($6,000/year). ABC Academy also owns comparable lodging that it rents to other individuals for an average of $600/month ($7,200/year). The appraised value of Smith’s residence at the end of the calendar year is $100,000. Under Section 119(d)(2), Smith does not have to include in her income any portion of the value of the lodging because her rent exceeds $5,000 (5 percent of the appraised value of the residence), despite the fact that her rent is less than the comparable average.
However, at the end of the following year, the residence has appreciated in value to $150,000. In this case, Smith must include an additional $1,200 in her income. This is the difference between her $6,000 rent and the $7,200 average rent paid by other individuals. Why $1,200? Because 5 percent of the home’s appraised value of the residence is $7,500, and $7,200 is less than that. Therefore, the lower of those two amounts is compared to the actual rent Smith pays, and the difference is taxable income on the Form W-2.
Here’s another hypothetical example. XYZ Academy owns a residence near its campus that it provides at no charge to David Jones, head of school. The residence is valued at $500,000, and the school does not own any other residences for which it receives rent. Since Jones is paying inadequate rent (below the safe harbor amount of $25,000), $25,000 is included on his W-2 as taxable income. This is the result since there are no comparable rents that others pay to the school.
There are extensive case studies and court decisions involving the tax compliance of employer-provided housing, and indeed a great many ways the benefit could (and does) play out at independent schools. Until the tax code is changed, business officers are advised to include tax advisors and legal counsel in developing any kind of a housing-related benefit. When it comes to tax compliance, the additional front-end work always pays off in the long run.
James P. Sweeney, CPA, is a partner and national lead of the Exempt Organizations Technical Tax Services division at RSM US LLP (formerly known as McGladrey), which provides specialized audit, tax and consulting services to organizations including K–12 independent schools.