IRS Overhaul of Fringe Benefit Test Reflects Modern Realities

A Treasury Department and IRS proposal to update the antiquated “line of business” test that employers use to calculate tax-free fringe benefits would reconcile benefit administration with modern economic realities and foster consistency across the Internal Revenue Code.

The move would replace the Enterprise Standard Industrial Classification Manual—a system that predates the internet and even the personal computer—with the North American Industry Classification System, which evolves every five years.

Tax professionals should begin mapping clients’ operations to NAICS industry groups, revisiting aggregation analyses, and updating internal controls. Early preparation will smooth the transition once the regulations are finalized and help ensure that valuable employee-discount and no-additional-cost-service programs remain within the exclusions under tax code Section 132.

Importance of ‘Line’

Both the qualified employee discount and no-additional-cost service exclusions hinge on the employee working in the same “line of business” that produces the discounted or no-additional-cost property or service.

Section 132(a)(2) excludes from an employee’s gross income any qualified employee discount on goods and services offered by the employer in the regular course of business, provided the discount doesn’t exceed statutory limits, thus treating it as a fringe benefit exempt from income and employment taxes.

Section 132(a)(1) excludes from gross income any “no additional cost service” provided by the employer to the employee, as long as the service is ordinarily offered to customers and doesn’t create substantial incremental costs to the employer.

Congress imposed this limitation to prevent employers from extending tax-free benefits unrelated to the employee’s actual duties (such as an airline mechanic receiving complimentary meals at an affiliated restaurant chain).

Determining whether an employee and the offered benefit share a single line of business therefore is pivotal in deciding whether the fringe benefit is excludable.

The line-of-business concept is used in other areas of the tax code. An example is the safe harbors available for qualified separate lines of business used to segment an employer’s workforce for certain employee benefit plan nondiscrimination testing purposes.

The proposed regulations don’t affect the definitions used in contexts other than the employee discount and no-additional-cost-service exclusions.

Proposed Changes

This overhaul has several principal features:

Adoption of NAICS four-digit industry groups: The proposal would define an employer’s line of business by reference to the NAICS four-digit industry group classification. An employer will be treated as conducting more than one line of business if it sells goods or services in more than one industry group.

Regular updates: NAICS is refreshed every five years, most recently in 2022, ensuring that emerging industries—such as broadband providers, app developers, and other technology sectors—are captured in a timely manner. This stands in stark contrast to the ESIC Manual, which has remained static for more than 50 years.

Conforming to aggregation rules: The proposal retains existing aggregation concepts (such as integrated operations, multi-role employees, and single-premises retail) but modernizes the examples and substitutes references to “general merchandise stores, including warehouse clubs and supercenters” for the outdated “department store” analogy.

Applicability and transition: The regulations would become effective for taxable years beginning on or after the date final rules are published. The rules didn’t include a concept of grandfathering for employers who have relied on the prior methodology to minimize the regulatory burden of re-analyzing whether the same line of business will still apply.

Harmonization with other tax code provisions: NAICS codes already appear in numerous IRS forms and procedural guidance—such as Form 1120 (Principal Business Activity Code). Aligning fringe-benefit rules with existing uses promotes uniformity and simplifies compliance.

Practical Considerations

While we await the final rules, employers may want to reassess their NAICS classifications at the four-digit level and determine whether employees previously deemed to be in a single line of business continue to qualify.

Because NAICS focuses on establishment-level rather than enterprise-level activity, larger organizations with diversified operations may discover additional lines of business for exclusion purposes—or conversely may be able to aggregate functions previously treated separately.

Payroll and benefits platforms often rely on coding structures to confirm eligibility for fringe-benefit exclusions. Updating these systems to accommodate four-digit NAICS codes will be essential. Employers may want to consider maintaining contemporaneous records demonstrating how each establishment’s primary activity aligns with the relevant NAICS industry group.

A more granular classification system may prompt auditors to challenge aggressive aggregation positions previously accepted under the broad ESIC categories. Practitioners should revisit positions that rely on the “difficulty-of-allocation” or “common premises” aggregation rules to ensure they remain defensible under NAICS.

In some cases, the richer detail of NAICS may facilitate aggregation by showing that certain operations are naturally grouped together in the modern marketplace (such as cafés selling related appliances). This could broaden the scope of tax-advantaged benefits without additional cost to employers.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Carly E. Grey is shareholder at Ogletree Deakins in Washington, DC, focusing on employee benefit and executive compensation matters.

Michael Mahoney is a shareholder at Ogletree Deakins in Morristown, New York, focusing on federal and state employment tax matters.

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