Are you providing cell phones or PDA's to your employees?  If you are, you need to beware of the Internal Revenue Service which has started to review of personal use of company-provided cell phones in its audits.  Why does the IRS believe there is an issue?

The answer is found in amendments to the Internal Revenue Code in 1989 when Congress defined "listed property" to include cell phones.  Listed property includes items obtained for use in a business, but designated in the IRC as lending themselves easily to personal use. Besides cell phones, other "listed property" includes automobiles, computers, and entertainment or recreation-related items.  When an employee uses anything considered as a listed property for personal use, such use is treated as additional wages and is subject to income tax withholding, FICA and FUTA taxes.

To exclude an employee's cell phone use from wages, an employer must require an employee to keep records that distinguish business from personal phone charges.  The calls that are personal in nature must be included in the employee's wages.  This includes not only the individual personal calls, but a pro rata share of monthly service charges as well.

IRS guidance provides the following three examples:

Example 1: A municipal government provides an employee a cell phone for business purposes. The government's written policy prohibits personal use of the phone. The government routinely audits the employee's phone billings to confirm that personal calls were not made. No personal calls were actually made by the employee. The business use of the phone is not taxable to the employee.

Example 2. A municipal government provides an employee a cell phone for business purposes. The government's written policy prohibits personal use of the phone. However, the government does not audit phone use to verify exclusive business use. The fair market value of the phone, plus each monthly service charge and any individual call charges are taxable income to the employee, reportable on Form W-2.

Example 3: A state agency provides an employee with a cell phone and pays the monthly service charge. The employee is required to highlight personal calls on the monthly bill. The employee is then required to timely reimburse the agency for the cost of the personal calls, and the employee is charged a pro rata share of the monthly charge. The value of the business use portion of the phone is not taxable to the employee.

The IRS is now making auditing of cell phone records a standard practice, and many employers have been caught unaware in recent audits.   Because many employers have not followed the substantiation requirements, they have been hit with assessments for failure to report and pay over the employment taxes owed on the personal use of cell phones.

Employers should be wary of employees' personal use of employer-provided cell phones and should review their policies (or create a policy if none exists). Employers have several options under the current rules, including:

• Require employees to have their own cell phones and reimburse employees for business calls;
• Require employees to itemize each cell phone call on a monthly bill and provide a business reason for each business call;
• Prohibit employees from using employer-provided cell phones for personal use of any kind; or
• Treat the employer-provided cell phone as a taxable fringe benefit and impute income to the employee for the entire cost of the service.

There is some good news on the horizon.  A bill was introduced in Congress called the "Moderize Our Bookkeeping In the Law for Employee's Cell Phone Act of 2008."  This bill, if passed, would eliminate the employment tax consequences of personal use of cell phones by deleting cellular phones from the items treated as "listed property" under the IRC for tax years beginning on January 1, 2008.  The intended effect of removing cell phones from among the items treated as listed property is to eliminate the burdensome recordkeeping requirements and the employment tax consequences of employees using their employer-provided cell phones for personal use.

Susan Fahey Desmond