Guest Article

(From the December 4, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Guidance on Using Smartcards and Debit Cards to Provide Mass Transit Benefits

The IRS has issued Revenue Ruling 2006-57, 2006-47 I.R.B. 911, to provide guidance on the substantiation procedures employers must use when providing mass transit benefits through smartcards and debit cards. Significantly, the revenue ruling confirms that employers do not have to require employees to substantiate how they use smartcards or debit cards that can be used to purchase only transit passes. However, substantiation is required if the smartcard or debit card can be used for other purposes.

Background

The value of certain employer-provided "qualified transportation fringe" benefits are not included in employees' gross incomes for federal income tax purposes, up to specific limits. IRC § 132(a)(5). A "qualified transportation fringe" is transportation in a commuter highway vehicle, any transit pass, and qualified parking. The following chart specifies the limits on the gross income exclusion for qualified transportation fringe benefits for 2006 and 2007.

Employers generally can provide qualified transportation fringe benefits by reimbursing employees for the cost of these benefits. However, cash reimbursements for transit passes are permitted only if "a voucher or similar item that may be exchanged only for a transit pass is not readily available for direct distribution by the employer to the employee." A voucher or similar item is readily available "if and only if the employer can obtain it from a voucher provider that does not impose fare media charges greater than one percent of the average annual value of the voucher for a transit system, and does not impose other restrictions causing the voucher not to be considered readily available."

Cash reimbursements, when permitted, must be made pursuant to a bona fide reimbursement arrangement. This means reimbursements can be made only for expenses that have already been incurred. Also, the employer must implement reasonable substantiation procedures. This usually involves collecting receipts from employees. But if the seller of the parking or transportation services does not provide receipts in the ordinary course of business, employers can accept employee certifications if they have no reason to doubt such certifications. However, employers may not rely solely on employees certifying that they will incur eligible expenses sometime in the future. There are no substantiation requirements if the employer distributes transit passes (including vouchers or similar items) in-kind to employees.

As noted, the value of employer-provided qualified transportation fringe benefits, up to the specified limits, are not included in employees' gross incomes for federal income tax purposes. These amounts also do not count as wages for purposes of the Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) payroll taxes, or for purposes of the federal income tax withholding requirements. See IRC §§ 3121(a)(20), 3306(b)(16), and 3401(a)(19).

Summary of Rev. Rul. 2006-57

The revenue ruling describes four situations in which employers give employees "smartcards" or debit cards to use for mass transit fares. The issue in each situation is whether the employer's methods for delivering these benefits and substantiating employees' expenses are consistent with the requirements for providing qualified transportation fringe benefits that are excluded from employees' gross incomes pursuant to IRC §§ 132(a)(5) and 132(f). The first two situations, which are the most straightforward, are as follows:

In both of these situations, the revenue ruling concludes the value of the employer-provided transit pass benefits are excluded from employees' gross incomes and wages. The reason is that the smartcard and terminal-restricted debit card can be used only to purchase fare media for the relevant transit systems, and thus are transit vouchers the employers are distributing in-kind to their employees. As a result, there is no requirement for the employers to substantiate how their employees are using the smartcards and terminal-restricted debit cards. Also, the maximum allocation to the smartcards and terminal-restricted debit cards each month does not exceed the $105 aggregate monthly limit (in 2006) for transit passes and transportation in a commuter highway vehicle.

The third and fourth situations are a bit more complicated because vouchers or similar items that can be exchanged only for transit passes are not "readily available" for the employer to purchase and distribute directly to its employees. Instead, the employer provides debit cards to employees that can be used only at merchants that have been assigned a merchant category code (MCC) indicating they sell fare media. However, these merchants may sell other merchandise, and there is no way to prevent employees from using these debit cards to buy such other merchandise. The maximum amount allocated to the debit cards each month is $105.

The difference between Situation 3 and Situation 4 is the substantiation procedures the employer uses. In Situation 3 the employer allocates up to $105 to an employee's debit card on an after-tax basis for the first month of the employee's participation. The employee then must substantiate the amount of fare media expenses incurred during that first month, and the employer then contributes the substantiated amount to the employee's debit card on a tax-free basis. The same procedure is followed for subsequent months.

In order to substantiate expenses paid with the debit card, the employer in Situation 3 receives periodic statements with information about how each debit card was used. This information includes the identity of the merchant and the date and amount of each transaction. Also, before the first reimbursement and annually thereafter the employee must certify that the debit card was used only to purchase fare media.

By comparison, the employer in Situation 4 provides employees with MCC-restricted debit cards as soon as they begin work. The employees must certify that they will use the cards only to purchase transit passes before they can use them the first time. Also, each debit card includes a statement that the card is to be used only for transit passes and, by using the card, the employee certifies it is being used only to purchase transit passes. The employees are not required at any time to substantiate the amount of fare media expenses actually incurred.

The revenue ruling concludes the value of the employer-provided transit pass benefits are excluded from employees' gross incomes and wages for employment tax purposes in Situation 3, but not in Situation 4. In both cases the debit cards are not transit system vouchers because employees can use them to purchase items other than transit passes. Thus, the gross income and wage exclusions apply only if the employer-provided reimbursements are made pursuant to a bona fide reimbursement arrangement. The arrangement in Situation 4 does not meet this standard because "it provides for advances rather than reimbursements and because it relies solely on employee certifications provided before the expense is incurred."

Guidance to Come on When Terminal-Restricted Debit Cards are Readily Available

As noted, employers may not provide cash reimbursements for transit passes if vouchers or similar items are "readily available." Thus, when a terminal-restricted debit card is readily available, cash reimbursements are not allowed. However, there currently is no guidance from IRS on when terminal-restricted debit cards are readily available, and the IRS has concluded it lacks "sufficient factual context to develop guidance at this time." Until the IRS does issue guidance, the revenue ruling provides the IRS "will not challenge the ability of employers to provide qualified transportation fringes in the form of cash reimbursement for transit passes when the only available voucher or similar item is a terminal-restricted debit card."

Effective Date

The revenue ruling is effective January 1, 2008. However, employers and employees can rely on the revenue ruling with respect to transactions occurring before that date.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2006, Deloitte.