Classic Lesson From Tax Court: The Convenience Of The Employer Doctrine

Recently a grand jury in New York indicted a man named Allen Weisselberg for tax evasion.  Mr. Weisselberg worked at his employer’s offices in lower Manhattan.  Until March 2005, Mr. Weisselberg lived in Long Island and apparently commuted from there.  In March 2005 he moved into an apartment in the Upper West Side of Manhattan, a much shorter commute.  As of 2021 he has never paid rent.  Instead, his employer has paid his rent, amounting to some $100,000 per year according to the indictment.

Mr. Weisselberg accounted to his employer for the value of the lodging, recording it as part of his $940,000 yearly compensation and receiving less cash as a result.  But Mr. Weisselberg did not account for the free lodging to the state or federal tax authorities.  He did not report it as income.

While the indictment is under state law, commentators have also suggested that Mr. Weisselberg violated federal tax law.  Did he?  After all, §119 allows taxpayers to sometimes exclude free lodging when it is provided for the convenience of the employer.  And it would not be surprising if Mr. Weisselberg’s famously demanding employer in fact required Mr. Weisselberg move much closer to the office.

This gives us a great reason to review the classic case of Benaglia v. Commissioner, 36 B.T.A. 838 (1937) (Judge Sternhagen), where the Tax Court laid the modern foundation for the convenience of the employer doctrine, a doctrine now incorporated into the §119 exclusion.

Besides, it's summer.  That's a good excuse to review a fun case about a famous hotel in Hawaii, a hotel that you can still visit as part of your own personal tax tour of the United States.  Glorious details lie below the fold.

Law: Pre-Benaglia Confusion about Convenience of the Employer
In the early days of the modern income tax Courts were not sure about the scope of §61.  Famously, the Supreme Court in early cases had decreed that “gross income” meant only gains that could be sourced to either labor or capital.  See e.g. Doyle v. Mitchell Bros. Co., 247 U.S. 179, 195 (1918)(“Income may be defined as the gain derived from capital, from labor, or from both combined.”).

Accordingly, when the question arose as to whether meals and lodging furnished to sailors on a ship had to be reported as income, the IRS decided it would only be gross income if it represented compensation for labor.  The IRS concluded that the meals and lodging were better viewed as part of the employer’s cost of operation as opposed to part of the compensation for each particular employee’s labor.  This dichotomy between “employee compensation” and “employer cost” became part of the governing regulations with the latter idea getting tagged with the shorthand “convenience of the employer.”

The early regulations provided that “when living quarters such as camps are furnished to employees for the convenience of the employer, the ratable value need not be added to the cash compensation of the employee, but where a person receives as compensation for services rendered a salary and in addition thereto living quarters, the value to such person of the quarters furnished constitutes income subject to tax. . . .”  Treasury Regulations 45, Art. 33, as quoted in Commissioner v. Kowalski, 434 U.S. 77, 84-85 (1977).

The difficulty was in deciding whether meals and lodging were taxable “compensation” or whether they were just a cost incurred by the employer and not compensation for labor (hence provided only for the “convenience of the employer”).

Two approaches competed for primacy.  First was what one commentator has called the “employer-characterization” approach.  See Jane Zhao, Note, Nights On The Museum: Should Free Housing Provided To Museum Directors Also Be Tax-Free, 62 Syracuse L. Rev. 427 (2012).

Under the employer-characterization approach, the value of meals and lodging would not be included in income when employers and employees did not consider it to be compensation.  This approach relied on an examination of whether the parties had negotiated the meals and lodging to be part of compensation or whether the employer had treated the cost as compensation in its books of account.  Thus the answer would be found by looking at employment contracts or the employer’s books and records.  For example, an early IRS ruling said that employees of the federal Indian Service did not have to report the value of their furnished lodging as income if the Department of the Interior did not pay for the lodging using money from its appropriation for employee compensation.  Kowalski 434 U.S. at 85, note 16.

The second approach was the “business-necessity” approach. Kowalski, 434 U.S. at 87.  This approach disregarded how the parties labeled the provision of meals and lodging.  Instead, it looked at whether an employer’s business could function properly without providing meals and/or lodging to employees.  If the business depended on employees being physically present, such as on a ship, why then the meals and lodging were a cost of doing business apart from compensation for the labor.

Benaglia is the leading case for the business-necessity approach.  This is a bit ironic because the taxpayer there actually won.  Let’s take a look.

Facts and Lesson of Benaglia
In 1925 the Territorial Hotel Company owned two hotels in close proximity to each other on Waikiki Beach: the Moana Hotel (built in 1901) and the Honolulu Seaside Hotel.  In 1925, the Company demolished the latter and began construction on a replacement luxury hotel.

To manage both properties the Company hired Arthur Benaglia who had “lifelong experience in hotel management and operation in the United States, Canada, and elsewhere.”  36 B.T.A. at 839.  In his letter accepting the employment Mr. Benaglia wrote his understanding of the hire:

“Confirming our meeting here today, it is understood that I will assume the position of general manager of both the Royal Waikiki Beach Hotel (now under construction) and the Moana Hotel in Honolulu, at a yearly salary of $10,000.00, payable monthly, together with living quarters, meals, etc., for myself and wife. In addition I am to receive $20.00 per day while traveling, this however, not to include any railroad or steamship fares, and I to submit vouchers monthly covering all such expenses.”

The Royal Hawaiian opened in February 1927 and Mr. Benaglia and his wife lived in a suite of rooms.  The hotel continued operation even through the Great Depression and Mr. Benaglia continued as general manager.  Although his cash salary varied over the years, he and his wife continued to receive free meals and lodging at the Royal Hawaiian with no accounting.

In auditing his 1932 and 1933 returns, the IRS (then called the Bureau of Internal Revenue, or BIR) thought Mr. Benaglia should have accounted for the value of the meals and lodging as income, to the tune of almost $8,000 per year.  That would be about $160,000 in today’s dollars.

The Tax Court (then called the Board of Tax Appeals, or BTA) was divided.  Most judges agreed that Mr. Benaglia could exclude the value of meals and lodging.  Some dissented, believing it was compensation income.  The split in opinion provides our lesson.

The main disagreement between the majority and dissent was about how to apply the employer-characterization approach.  The majority emphasized that neither Mr. Benaglia nor the employer viewed the meals and lodging as compensation because “[the] corporation’s books carried no accounting for the petitioner’s meals, rooms, or service.”  36 B.T.A. at 840.  In contrast, Judge Arnold, writing a dissent joined by three other judges, pointed to Mr. Benaglia’s letter:  “This letter, in my opinion, constitutes the basic contract of employment and clearly shows that the living quarters, meals, etc., furnished petitioner and his wife were understood and intended to be compensation in addition to the cash salary paid him.”  36 B.T.A. at 841.

Thus, if the case were to be decided using the employer-characterization approach, there was definitely room for disagreement.

But the majority did not rest its decision on the employer-characterization approach.  It instead adopted the business-necessity approach.  It explained that the meals and lodging were not income because they were necessitated by the business.  The general manager needed to live in the hotel, regardless of the manager’s personal preferences.  It was not “for his personal convenience comfort or pleasure, but solely because he could not otherwise perform the services required of him.”  Id. at 839. The Court explained that “...the functions of the manager could not have been performed by one living outside the hotel, especially a resort hotel such as this. The demands and requirements of guests are numerous, various, and unpredictable, and affect the meals, the rooms, the entertainment, and everything else about the hotel. The manager must be alert to all these things day and night.  He would not consider undertaking the job and the owners of the hotel would not consider employing a manager unless he lived there.”  Id. at 839-840.

Judge Arnold also disagreed with this, asking why Mr. Benaglia had to live in the Royal Hawaiian when he was also supposed to manage the other hotel, the Moana.   The majority did not address this point but a quick look at Google maps supplies the answer: the hotels were almost next door to each other.

Thus, Benaglia adopted the business-necessity approach to the convenience of the employer doctrine.  The Tax Court reaffirmed this approach 14 years later in Van Rosen v. Commissioner, 17 T.C. 834 (1951) where the Court decided that a military officer had to include in income a cash housing allowance he received during the time his ship was undergoing repairs in drydock.  The applicable military regulations provided that the allowance was not compensation but specifically said the allowance was “for the convenience of the Government.” 

The Tax Court in Van Rosen pointed out that the regulation’s characterization of the payments did not really matter because what mattered was the the economics and not the employer's characterization as compensation.  Rejecting the employer-characterization approach, the Court wrote: “The better and more accurate statement of the reason for the exclusion from the employee’s income of the value of subsistence and quarters furnished in kind is found, we think in Arthur Benaglia, 36 B.T.A. 838.”  The Court then explained the business-necessity Benaglia holding as follows:

“In other words, though there was an element of gain to the employee, in that he received subsistence and quarters which otherwise he would have had to supply for himself, he had nothing he could take, appropriate, use and expend according to his own dictates, but rather, the ends of the employer’s business dominated and controlled, just as in the furnishing of a place to work and in the supplying of the tools and machinery with which to work.”

Applying the business-necessity approach, the Tax Court held that the cash allowances could not be excluded from gross income. 

Codification of Tax Court Doctrine into §119
In 1954 Congress codified the meals and lodging exclusion as §119, even titling titled it “Meals or lodging furnished for the convenience of the employer.”  Section 119 was intended to “end the confusion as to the tax status of meals and lodging furnished an employee by his employer.” H. Rep. 83-1337 at 18, as quoted in Kowalski, supra, at 90.

However, the enactment of §119 once again raised the conflict between the employer-characterization approach and the business-necessity approach.  The House proposed a version of §119 that would have omitted “convenience of the employer” as a requirement for exclusion.  Under the House version, it would sufficient if the meals and lodging were simply furnished on the business premises and at the request of the employer.   That would have basically codified the employer-characterization approach, as now limited by the business premises requirement.

However, the Senate rejected the House proposal and insisted on re-inserting the convenience of the employer idea.  434 U.S. at 90-91.  Thus, as written, §119 permits taxpayers an exclusion for the value of meals or lodging provided by their employers when the benefits meet three conditions: (a) they are provided on the business premises, (b) they are provided for the convenience of the employer, and (c) in the case of lodging, they are provided as a condition of employment.

Not only did Congress incorporate the “convenience of the employer” idea, the final version of §119 specifically codified the Tax Court’s understanding of what constituted convenience of the employer.  Wrote the Supreme Court in Kowalski: “judicial development of the convenience-of-the-employer doctrine centered primarily in the Tax Court. In two reviewed cases decided more than a decade apart...that court settled on [a] rationale for excluding food and lodging from an employee’s income.”  434 U.S. at 88 (citations omitted).   Using the Tax Court's approach, the Supreme Court had no difficulty finding that cash meal allowances to New Jersey state troopers could not be excluded from gross income.

And it all started with Benaglia.  It’s a classic Lesson From The Tax Court.

Coda: One quickly sees why Mr. Weisselberg has zero chance of claiming a §119 exclusion: his lodging is not on his employer’s premises, thus failing one of the key statutory requirements for the exclusion.  Even if the lodging were on his employer’s premises (perhaps his employer considers all of Manhattan his business premises?), it is difficult to fathom what possible business necessity would require lodging in the Upper West Side for office work downtown.   Finally, while I am no criminal law expert, the double set of books kept by Mr. Weisselberg appear quite damming.  See Daniel Shaviro: "The Weisselberg Indictment is Not A 'Fringe Benefits' Case," Just Security blog (July 4, 2021).

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech School of Law.  He invites readers to return each week to TaxProf Blog for another Lesson From The Tax Court.