Donald Tobin (Ohio State), co-author of the acclaimed student tax hornbook Principles of Federal Income Taxation Law (West, 7th ed. 2005) (with Daniel Posin), sparked an extended discussion in the TaxProf Discussion Group on the lurking tax issue faced by law students who work as representatives for Bar/Bri and other bar exam prep courses (and who organize spring break trips for tour companies). With their permission, we reprint below Donald’s comments as well as those of two of the more active and thoughtful TaxProf members, Jim Maule (Villanova) and Mike McIntyre (Wayne State) [Note to third year student bar reps: you may want to stop reading here!]
I constantly tell my students in tax class that compensation is compensation, whether it is cash or property. But companies compensate students in such creative ways, it often becomes difficult to determine how to tax the compensation. For example, a tour group may provide a “free” spring break trip to a person who organizes a trip with at least 10 students, or a law bar review course may provide a free course to its sales representatives. The question is what should the tax result be for students who are compensated in this manner?
The first question is whether the students are employees or independent contractors. The employers may argue that the students are independent contractors, but in many cases, the companies exercise a significant degree of control over the students, thus making the independent contractor claim difficult. If the students are independent contractors, then they owe tax on the fair market value of the product or services they receive. They are also likely subject to employment tax at 15.3%. Thus a “free” spring break trip valued at $500, or a bar review course costing $2,500 may end up costing the student about $175 and $875, respectively, in total tax liability.
If the students are not independent contractors, then the students are only subject to the employee half of the employment tax. This raises the question if you can be an employee if your only compensation is the property you are trying to exclude as a fringe benefit. (This problem also arises in the cruise industry. Cruise lines often provide free cruises to individuals who give lectures on the cruise.) If the students are employees, they may be able to exclude some of the compensation as a fringe benefit under § 132 of the Code.
The compensation could be considered a no additional cost fringe benefit under § 132(a)(1), but that section only applies to services and requires that the employer incur “no substantial additional cost” in providing the service. In both the spring break and bar review context that argument may be hard to make. The extra spring break trip clearly costs the promoter money, and is likely not a “service.” The promoter needs to buy another plane ticket and another hotel room. But what about in the bar review situation? Are the books really a no additional cost fringe? Are they extra, or could they be kept in inventory and sold to others? They are not like an extra non-reserved seat on an airline. Even if the bar review is provided at no additional cost, is it a “service”? The bar review course includes books and materials, but the bar review lectures are arguably a service.
Even if students can’t exclude under § 132(a)(1), if they are employees, they can likely exclude some of the income under 132(a)(2), as a qualified employee discount. If bar review is considered a service they could receive a 20% discount on the price of the service without having to pay tax on that amount, and if it is property, they could receive a discount up to the gross profit percentage.
The informal comments I have received from former students is mixed. There is some indication that some of them have received 1099s and others have not. It may be that different providers treat students differently. I would be interested to know how this theoretical issue is treated outside the classroom.
Reprinted below is the echange between Jim Maule and Mike McIntyre on the issues raised by Donald:
Maule #1
Does BAR-BRI normally sell DVDs? If not, then neither the no substantial additional cost or qualified employee discount exclusions would be available. If BAR-BRI purchases DVDs and sells them to students at cost, then the applicable gross profit percentage would be zero, so again, no exclusion.
As for the materials and the course, which BAR-BRI is in the business of selling, they might be akin to the hotel room provided by the employer of a hotel chain employee. BAR-BRI surely contracts for printing in round lots, which means a pile of "leftovers" that otherwise would be trashed, much like the vacant hotel room. And surely no one is bounced from the room to make a space for one more student listening to the BAR-BRI lecture.
No working condition fringe, of course. The students aren’t yet carrying on a trade or business.
Maule #2
Back in the 1980s, when the "save money by treating law student hires as independent contractors" craze swept the law firms, the IRS cracked down. My annual "poll" of students on this question, when we reached the point in the course where we address the issues, went from roughly 80% independent contractor to just 1 or 2 students. Now it’s beginning to move up again.
Why?
Some inquiries have revealed that the attorneys who do this are almost always practicing in areas far removed (or that they think are far removed from taxation), such as personal injury attorneys. My guess is that they are among the folks who avoid tax because it’s boring, too challenging, or dangerous to the transcript.
In one instance, about two years ago, a student went to his "employer" and told him what I had said in class about the difference between employees and independent contractors. The attorney’s comment was along the lines of "if the IRS catches me, I’ll worry about it then." The student, now understanding the whipsaw position in which he found himself, was not happy.
I advise students to ponder the advantages of reporting the "employer’s" practice with the disadvantage of doing so. It is a very tough introduction to making decisions in light of professional ethics.
Maule #3
I was also told that once the IRS started looking into a few law firms’ treatment of law students hired as summer and part-time associates, that word spread and firms quickly changed course. Whether they filed amended returns is unclear, though I also heard from another student that (much to my surprise) the employer notified him that it had made employer contributions to social security. The student had come to me to find out if he should amend his return, and move the income from Schedule C to the wages line, thus eliminating the need for, and the tax computed on, Schedule SE.
I tell students that what may appear to be a great hourly rate or weekly summer salary isn’t all that great if 15.3% must be paid for social security. I also point out the penalties they might face if they don’t file estimated tax returns. I tell them that the psychological shock of discovering taxes are due in April, compounded by the student’s previous expenditure of all monies received, is unkind.
When asked by students what to do when told they will be independent contractors and they are not, I advise them to inform the employer that a tax problem will loom. In several instances, I’ve expressed the opinion that filling out a return with "NO W-2 RECEIVED" and putting the amounts on the wages line will surely get the attention of the IRS. I simply have no sympathy whatsoever to employers who do this, and if the employer is a lawyer my lack of sympathy evolves into antipathy.
How law schools can let their students wander off after the first year into this maze of unethical behavior troubles me. Even if tax isn’t put into the first year, some sort of advising needs to be done. Of course, many non-tax faculty are blissfully unaware of the problem.
McIntyre #1
I disagree about the "surplus" materials. With hotel rooms, you have rooms for the long haul and sometimes have too many and sometimes too few. When you have too many, it is fair to say it is "no cost" to let the employee use it (of course, the whole concept of "no cost" is economic nonsense, but that is a different matter.
With text books, you order for a particular use, and you want to get the number right but not go under because of the cost of a new run. So, if you hired students after you did your run and gave them books that in fact were left over, then your analysis is fine. But if the hired students are taken into account when the books are ordered, then their books are part of the cost.
For example, if I expect 80 students but might get as many as 90, I order 90. And if I need 5 books for my hired students, I order 95. That extra five have a real cost, even if it turns out I trash 10 books. ONLY if the hired students definitely will not get a book if there is a shortage and the order number is not adjusted up to take account of the hired student can they be viewed as "no cost" — which is really just an invitation to fraud. And I’m assuming that the books are useless after the course — that they can’t be saved for the next round of the course. If they can be saved for the next time, then there is never a no-cost situation.
Maule #4
I agree with your theory. As a practical matter, though, when BAR-BRI is ordering THOUSANDS of books for a particular state’s bar exam, and has hired at most perhaps several dozen reps who will take that state’s bar, I’m sure an order for 1,500 or 2,000 would be made whether or not the books are sold to or distributed without charge to the reps. I’ve dealt with printers. Other than a custom "one book" print (very expensive), printers rarely deal with lots rounded to much less than 1,000 or, perhaps 500.
I don’t think BAR-BRI saves the excess, because (1) law changes and (2) they want that current year date on the cover so that they can give students the impression they’re getting the most up-to-date materials for the many $$$ the students are shelling out. If textbook costs have spiraled, try figuring out the increase for bar review courses!!!
McIntyre #2
I still disagree. I think the cost of an inventory item is its inventory cost. If I run a shoe store and give shoes to the help, I cannot claim "no cost" on the claim that I never sell all my shoes, even if the claim is right.
Also, your experience with printers differs from mine, but I’m accepting your experience for purposes of the hypo.
An interesting side point is whether books that you will actually junk can be given away as "no cost" if the reason you are junking them is that you do not want to sell them at a "market" price for fear that people will just buy the book and not take the course. In my view, if they have a significant, non-de minimis value, they are not "no cost" even if you choose not to sell them for marketing reasons.
Maule #5
The initial question is whether the book qualifies as a service. Use of a hotel room qualifies as a service. Why not use of a book? Is it the transfer of title?
Assuming that section 132(a)(1) applies, I’m not arguing "no cost" but "no substantial additional cost." If the estimate of need, aside from student reps, is 1,385 but the printer requires a 1,500 order because of lot rounding to 500, the cost is the same whether the dozen or dozen and a half student reps receive books free of charge or not. As a practical
matter, the cost per book under these circumstances (softbound) will be $25 …. surely not "substantial" even if there is a way to demonstrate that it is "additional."
Otherwise, there would be gross income equal to (100% – gross profit percentage) x cost of the book. Another practical problem is separating the price of the BAR-BRI course into its components, namely the book, the DVD, the lectures, the practice exams, etc.
As a practical matter, the book surely would fit within de minimis.
Whether $25 or $30, it surely isn’t $150.
The lectures would be no substantial additional cost. That portion of the arrangement is pretty much the same as the excess capacity hotel room.
McIntyre #3
I understand what we mean by "no cost" in this situation. I agree there is a "services" issue, but I was only addressing the issue on the assumption it was "goods". I agree with your "services" analysis.
I do not think that $25 per book is either de minimis or "not substantial," and I think those are two separate tests under the Code and should not be conflated. Obviously the $25 per book is not de minimis for the de minimis rule, since we would aggregate all the books to make that determination — the issue is whether it is too small to make accounting worthwhile, and the easy accounting and significant aggregate amount makes it well worth while to keep records (indeed, the records almost certainly already exist).
There is no de minimis rule under the no cost test. Whether there is a substantial additional cost in providing a book depends, as you indicate, on whether we think the book is free. If it is a free good because of your "extra book" theory, then the "no cost" is clearly met.
But if we decide that the book had a cost of $25, then there clearly is a substantial additional cost in giving the employee the book. The issue is there is a substantial additional cost is giving an employee a benefit worth $25. If the answer is that there is a cost of $25, then there can be no question that there is a substantial additional cost — the cost is the entire amount of the benefit.
As previously noted, I can agree that extra books are properly viewed as "free" for purposes of the "no cost" rule if, at the time, we made our order without reference to the desire for those extra books and then ended up with extra books. So, on that issue, there is a factual matter to be decided, and I’ll accept your hypothetical facts.
But if BAR-BRI uses on of those photocopying publishing systems (not unreasonable if it plans not to keep any inventory and has a run under 1,000), then you can order whatever number you want, so there are never any "free" books. Under that set of facts, I think the fringe is clearly taxable.
Maule #6
Right you are that if BAR-BRI is using a "print to demand" system there will be additional costs. But the per-book price on "print to demand" is higher than the per book price on batch (which of course requires that troubling "guess" as to how many to print; been there, done that). So it is a good fact question … what is BAR-BRI doing? Not that we necessarily can find out.
I use the term de minimis in the "tiny" sense (and not in its exclusionary sense) when discussing substantial because if something is de minimis (tiny) it can’t be substantial. Poor choice of a term on my part. Minuscule would be better except that it connotes REALLY tiny and that’s not quite my point. Sorry for the confusion.
Factually, the benefit of the book would be what the student would have to pay on the market, presumably more than cost. At what point does substantial become insubstantial? $25 cost for a $50 book? $75 book? If BAR-BRI is like other publishers, my guess is that cost (ignoring overhead) is a small (not minuscule) portion of the value (selling price). Again, how would we find out?
Maule # 1
