Opinion
Civil No. 4-01-CV-10176
August 21, 2002
ORDER
The Court held a bench trial July 23 through 25, 2002 after having previously denied defendant's motion for summary judgment by order of May 31, 2002. The parties submitted post-trial briefs, and the matter is flow fully submitted.
Insofar as relevant, the Court's discussion of applicable law in its prior summary judgment ruling is incorporated as a part of this Order.
The Internal Revenue Service ("IRS") asserts that the cost of employee fishing trips paid for by plaintiff, Townsend Industries, Inc. ("Townsend"), in 1996 and 1997 constituted wages upon which employment taxes should have been paid. The IRS assessed additional employment taxes for those years, and plaintiff asserts the employment tax deficiencies were improperly assessed. On June 16, 2000 plaintiff paid $100.00 of the assessed employment tax deficiency for the 1996 fishing trip, and filed the present lawsuit see a refund of this money on March 21, 2001. The government has since filed a counterclaim asserting it is owed the remaining tax deficiencies for 1996 and 1997.
I. FACTUAL FINDINGS
1. Plaintiff, Townsend Industries, was founded by Robert Townsend in the late 1950's. He is still the president and sole shareholder. Mr. Townsend invented the "T-51" printing press attachment, and the company manufactures and distributes several variations of this attachment.
2. The company is headquartered in Altoona, Iowa, where its factory is also located.
3. Townsend prides itself on being a different kind of company. Mr. Townsend terms it a "me too" company. Its business philosophy is to have employees choose to be a part of the company team, and not feel like they have to do certain things out of obligation. Townsend's goal is to treat its employees well and create an environment where employees will say "me too" when presented with opportunities to act in the company's interest.
4. The T-51 printing presses that Townsend manufactures are complex machines with approximately 800 different parts. See Plaintiffs Trial Exhibits 1 and 2 (brochures detailing the T-51 printing presses).
5. The attachments are distributed by both in-house sales personnel along with individuals from independent corporations. The sales personnel are located throughout the United States, and in Great Britain and Austrailia.
6. In June of every year since its inception, Townsend has held sales meetings at its Altoona headquarters. Domestic sales personnel travel into town over a weekend, The sales meetings are conducted on Monday and Tuesday, and follow the same basic schedule every year.
7. John Jorgenson, chief executive officer ("CEO") of Townsend since 1990, along with Mr. Townsend and a few other select Townsend employees, meet with sales personnel for breakfast on Monday morning. Jorgensen then instructs sales personnel to go to the factory and tour the plant. Sales personnel are encouraged to introduce themselves to workers at the plant, talk with them, and make themselves more familiar with the factory's operations.
8. At 9:30 a.m. on Monday morning, the factory workers take a regularly scheduled coffee break. At this time, the sales personnel introduce themselves to everyone and briefly discuss how things are going in their sales region. This coffee break lasts approximately one half hour.
9. At approximately 10:00 a.m. on Monday morning of every year, the actual sales meeting begins. Most factory workers don't attend, although a few may be called into the sales meeting for brief periods of time to discuss specific issues. The sales meeting is facilitated by Jorgensen, and attended by engineers, sales personnel, and factory and office department heads.
10. A variety of topics are addressed in the annual sales meeting. Testimony at trial indicated that sales personnel will commonly report on technical problems that they are having with the performance of the T-51 products, and potential solutions will be discussed. Other topics that are commonly addressed include advertising, trade shows, and relationships with the company's customers. Notes are taken throughout the meetings, and a final report is compiled by Jorgensen in the weeks following the meeting. See, e.g., Plaintiff's Trial Exhibit 6A (includes agenda, notes, and report from 1996 sales meeting).
11. This same week, Townsend annually sponsors a fishing trip for sales personnel and employees that runs Wednesday through Saturday.
12. Mr. Townsend and Jorgensen consider the fishing trip to be a part of the overall "me too" philosophy of the company. They hope that by placing sales personnel and employees in a comfortable and pleasant setting, business discussions will be encouraged and employees motivated to perform better for the company upon their return
13. The event is held at a five star resort called Totem Lodge in Ontario, Canada.
14. All employees at the Townsend factory are invited to attend. A sign-up sheet is posted months in advance of the trip, and employees are asked to indicate whether they are planning to attend and whether they plan to fish both days. See, e.g., Plaintiffs Trial Exhibit 7 at pages 23-25 (1997 trip sign-up sheet).
Jorgensen testified that Townsend used to have a plastics division and that its employees did attend some fishing trips, but neither of the trips in 1996 or 1997. The plastics division was operated at a different facility, and it was actually sold in 1997.
15. The trip is not mandatory, but Mr. Townsend and Jorgensen encourage everyone to attend. Regularly more than half of the employees attend.
16. The trip is substantially the same every year. Wednesday is spent taking a 12 hour bus ride up to the resort, Thursday and Friday are primarily spent fishing, and Saturday is a 12 hour bus ride back to Altoona, Iowa.
For those who do not want to fish, other activities such as golf or hiking are available.
17. Wives and children of Townsend employees and sales personnel are not invited to attend the fishing trip.
18. Testimony by Townsend employees was that the trip is an enjoyable time, but that it is not simply a vacation. The employees view it as a part of their job, and they are paid regular wages while on the trip.
19. Sales personnel and Townsend employees indicated that one to four hours per day were spent discussing Townsend related business. These discussions took place on the bus trips, at meals, on boats, and in cabins. Jorgensen and Mr. Townsend attempt to encourage these discussions in cabins and on boats by assigning specific individuals to be together during these times, although such assignments are flexible and can be changed for any reason.
20. Many subjects discussed at the sales meeting earlier that week were also discussed on the fishing trip.
21. Employees testified that they gained an advantage in performing their job by attending the fishing trip.
22. While there was testimony at the trial indicating that specific problems were solved on the fishing trip, there was not sufficient evidence presented to indicate exactly what the business discussions entailed and whether the discussions noted actually occurred in 1996, 1997, or in some other identifiable year. The testimony at trial indicated that all of the fishing trips "run together" because so many of the participants have attended for many years.
23. The only planned meeting on the trip is a fishing awards banquet on Friday night, and afterwards Mr. Townsend and Jorgensen give a "state-of-the-company" and motivational speech before the return to Iowa on Saturday.
II. APPLICABLE LAW DISCUSSION
A. Whether Fishing Trips Were Ordinary and Necessary
Certain items an employer gives to its employees are to be excluded from employees' gross income calculations, or in other words not made a part of employee wages. See 26 U.S.C. § 132. One such item that is to be excluded from the wage calculation is anything an employee receives from his or her employer which qualifies as a "working condition fringe." 26 U.S.C. § 132(a)(3). A working condition fringe is "property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under section 162 . . . ." 26 U.S.C. § 132(d). Under section 162, an "ordinary and necessary expense paid or incurred during the taxable year in carrying on any trade or business, including . . . traveling expenses (including amount expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business" are deductible by the employee. 26 U.S.C. § 162(a)(2).
To analyze the present controversy, this Court must therefore initially assess whether Townsend's fishing trip expenses in 1996 and 1997 were ordinary and necessary. "Although the terms `ordinary and necessary' have been repeatedly construed and applied, no definite standard can be formulated for determining whether a claimed deduction can qualify as an expense ordinary and necessary in the particular taxpayer's business." Wells-Lee v. Comm'r of Internal Revenue, 360 F.2d 665, 668-69 (8th Cir. 1966) (citing Welch v. Helvering, 290 U.S. 111 (1933) and Iowa Southern Util. Co. v. Comm'r of Internal Revenue, 333 F.2d 382 (8th Cir. 1964)). "In general, a business expense is tested by its normalcy and soundness considered in light of the nature of the taxpayer's trade or business, Byers v. Commissioner of Internal Revenue, 199 F.2d 273 (8th Cir. 1952), but the determination of whether an expense is ordinary and necessary and the taxpayer's purpose in making a particular payment are usually questions of fact." Wells-Lee, 360 F.2d at 669 (citing General Bancshares Corp. v. Comm'r of Internal Revenue, 326 F.2d 712 (8th Cir. 1964)).
In this Court's previous summary judgment ruling it determined that material issues of fact remained for trial as it could not determine, based on the record that was then before it, whether the fishing trips were an ordinary and necessary expense under section 162. In particular, the Court found that evidence at trial relating to whether the trip was mandatory and whether it could properly be viewed as a continuance of the Monday and Tuesday sales meeting would be important in making such a determination.
The majority of Townsend employees are not a part of the actual sales meeting on Monday and Tuesday as their role is generally limited to introductions and brief conversations with the sales personnel before the start of the actual meeting. See Factual Findings ¶¶ 7-9. All Townsend employees were invited and encouraged to attend the fishing trip, and while many do go year after year, other employees don't attend the trip. See Factual Findings ¶¶ 14-15. Business is certainly discussed on the fishing trip, but it is not done in an organized and monitored environment where Townsend's leaders are certain the sales meeting agenda is followed and discussions continued. See Factual Findings ¶¶ 19, 23. After evaluating the trial testimony, the Court concludes plaintiff's fishing trips were not an ordinary and necessary business expense in light of the lax attendance policy for the trip, and the disconnect between the sales meeting and the fishing trip.
In advancing its position, Townsend asserts that while the fishing trip may not be ordinary, neither is its whole business philosophy, see Factual Findings ¶¶ 3, 12, and that it should not be penalized for its ingenuity. Townsend urges that the Eighth Circuit's decision in Poletti v. Comm'r, 330 F.2d 818 (8th Cir. 1964) supports its position. The Court in Poletti addressed the deductibility of business expenses under section 162 as ordinary and necessary. Plaintiff in that case ran an employment agency and gave free gifts, both to individuals who sought placement through it and to companies where it placed employees. Plaintiff sought to deduct such expenses as ordinary and necessary. Id. at 819-20. The Court described these gifts as "really nothing more than a form of promotional advertising to advance its business, " and that the company should not be "penalized taxwise for business ingenuity in utilizing advertising techniques which do not conform to the practices of one whom he is naturally trying to surpass in profits." Id. at 821-22.
As this Court commented at trial, it has a deep respect for the plaintiff company, its founder Mr. Townsend, and their business philosophy. The company's success for over forty years dramatically reflects the legitimacy of the "me too" business philosophy espoused by Mr. Townsend and his wife since the company's inception. However, despite this Court's personal beliefs about the merits of Townsend's methods, including the value of the fishing trip to the business, Townsend simply is not exempt from the reach of the tax code and its regulations because it is an exemplary employer who genuinely cares about its employees and community.
The case at hand is distinguishable from Poletti. The Court found no caselaw supporting classifying expenditures for a voluntary, company-wide, all-expenses-paid, employer-sponsored fishing trip with one brief business meeting as an ordinary and necessary business expense. Townsend also argues Peoples Life Insurance Company v. United States, 373 F.2d 924 (Ct.Cl. 1967) supports its position, but in that case, the employer-paid-for-trip was for specific sales agents and it included two hour business meetings each day. The case made clear that the business meeting status of the event was not destroyed because pleasurable pursuits were also included, and the Court took stock in the fact that actual business meetings were held. Id. at 373 F.2d at 929. The fact that only a brief business meeting was held on the Townsend fishing trips is a factor in finding the trip was not an ordinary and necessary expense.
Now that the trial has been completed and this Court has made its factual findings, it finds that plaintiffs trips do not qualifly as a working condition fringe exempt from employee wage calculations.
B. Whether Fishing Trip Expenses Were Directly Related To or Associated With the Active Conduct of Townsend's Business
Even if this Court assumes Townsend's fishing trip expenses were ordinary and necessary under section 162, Townsend has to show the expenses were directly related to or associated with the active conduct of its business pursuant to 26 U.S.C. § 274(a)(1)(A).
A. In general. — No deduction otherwise allowable under this chapter shall be allowed for any item — (A) Activity. — With respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, unless the taxpayer establishes that the item was directly related to, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that such item was associated with, the active conduct of the taxpayer's trade or business.
26 U.S.C. § 274(e)(4) exempts an employer's recreational and social expenses from the reach of section 274 and its heightened requirements when those expenses are "primarily for the benefit of employees." However, as Townsend has asserted throughout this litigation that the expenses at issue in this case are ordinary and necessary business, and this Court is assuming for this stage of the analysis that the fishing trip expenses indeed do qualify as ordinary and necessary, the substantiation requirements of section 274(a) will be applied.
In order to show the fishing trip expenses were directly related to the active conduct of its business, Townsend needed to show at trial all of the following: (i) it had "more than a general expectation of deriving some income or other specific trade or business benefit" from the fishing trips; (ii) that active business discussions were conducted on the fishing trips; (iii) that the "principal character or aspect" of the fishing trips was the active conduct of business, although it is not necessary that more time was devoted to business than to entertainment; and (iv) the expenditure was allocable to Townsend's employees conduct of business and the other people on the fishing trip with which business was conducted. See 26 C.F.R. § 1.274-2(c)(3)(i-iv) (requiring all four requirements be met in order to find the expense directly related). Additionally, "[t]he active conduct of trade or business is considered not to be the principal character or aspect of combined business and entertainment activity on hunting or fishing trips or on yachts and other pleasure boats unless the taxpayer clearly establishes to the contrary." Id. at § 1.274-2(c)(3)(iii). Townsend did not meet this standard. It had an opportunity at trial to clearly establish that the principal character of its fishing trips was the active conduct of its trade or business, and it failed to do so. The trip was not an integral part of Townsend employees' ability to perform their jobs, it was not a part or a continuation of a sales meeting, but rather was a relaxed and fun event where business was discussed as part of the background to the primary fishing endeavor. 26 C.F.R. § 1.274-2(c)(3)(iii). Additionally, the testimony of Mr. Townsend and Jorgensen made particularly clear at trial that Townsend basically held an expectation to derive uncertain future benefits, particularly in the way of improved comradery and relations among its employees and sales personnel, from the fishing trip. Under 26 C.F.R. § 1.274-2(c)(3)(iii), such an expectation is not enough to allow the trips to qualify as directly related under section 274(a).
Nor can Townsend demonstrate that its trips were associated with the active conduct of its business. In order for this test to be met, the entertainment expense at issue must have been conducted before or after a business discussion. 26 U.S.C. § 274(a). "For example, if the taxpayer conducts substantial negotiations with a group of business associates and that evening entertains that group and their wives at a restaurant, theater, concert or sporting event, such entertainment expenses, if associated with the active conduct of the taxpayer's business, will be deductible even though the purpose of the entertainment is merely to promote goodwill in such business." Hippodrome Oldsmobile, Inc. v. United States, 474 F.2d 959, 963 (6th Cir. 1973) (discussing section 274 and related congressional reports); see also St. Petersburg Bank Trust Co. V. United States, 362 F. Supp. 674, 679 (M.D. Fla. 1973) (clearly stating that the "associated with" test is a less-stringent test that requires the business discussions, literally, immediately precede or follow the entertainment expense). Simply put, the Townsend business discussions that occurred in Iowa on Monday and Tuesday were too far distanced temporally from the fishing trip that took place the following four days for this Court to find the "associated with" test met.
Additionally, even if this Court were to assume Townsend could clear the aforementioned hurdles, it still needed to provide adequate substantiation of the business purposes of the fishing trip expenses at trial.
(d) Substantiation required. — No deduction or credit shall be allowed —
(1) under section 162 . . . for any traveling expense (including meals and lodging while away from home),
(2) for any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity,
. . .
unless the taxpayer substantiates by adequate records or by sufficient evidence corroborates the taxpayer's own statement (A) the amount of such expense or other item, (B) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property . . ., (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of persons entertained, using the facility or property . . . .26 U.S.C. § 274(d) (emphasis added). In this Court's May 31, 2002 order denying defendant's motion for summary judgment, the Court concluded that Townsend would need to present adequate records to substantiate the business purpose of the fishing trip expenses. At trial, Townsend did not provide such evidence. Summarized, the testimony at trial consistently indicated that the many years of fishing trips "ran together" and while most every witness remembered having business conversations on the fishing trips, the testimony about the business purposes of the trip lacked the necessary specificity. See Factual Finding ¶ 22.
III. CONCLUSION
For the above stated reasons, the Court finds that under the tax code and its governing regulations, Townsend expenses in taking its employees to Canada for fishing trips do not qualify for exclusion from wages to its employees. Townsend is liable for the employment tax deficiencies assessed by the I.R.S., which the parties have indicated are $24, 591.91 for 1996 and $33, 906.55 for 1997. The Clerk of Court shall enter judgment against plaintiff and in favor of defendant.