W ILLI AM E. PI LCHAK
DIRECT DIAL: 248.409.1919
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W P I L C H A K @ M I - W O R K L A
The Coming Crackdown on Per Diem?
William E. Pilchak
Pilchak Cohen & Tice, P.C.
William.Pilchak@MI-Worklaw.com
(248) 409-1900
People at every level know of abuses of per diem compensation by some staffing companies. A recruiter,
competing against other firms for the same candidate to fill the same position, loses out to a rival who promises
to provide a tax free per diem, even though the position will last more than one year and is within commuting
distance. Her manager recognizes the experience as part of a wider pattern, and asks top executives whether
they will similarly bend the rules and join the per diem free for all. Those execs ask attorneys for advice, but the
attorneys report that 2004 regulatory changes don’t authorize per diem in that situation, but only make violations
more difficult to police. Each person in that chain knows that others are profiting by skirting the rules.
Those skirting the rules profit: temporary employees avoid payroll taxes; recruiters earn commissions that
otherwise would not have come their way; managers and executives enjoy overrides and bonuses; and owners
not only enjoy profits from the assignments, but pocket between 8.5% and 10% of the per diem pay by avoiding
the FICA, FUTA, Medicare, and workers’ compensation contributions, all of which are based on payroll. All of
them are banking (literally) on hopes that the government will not discover their scheme.
They might be living on borrowed time.
The IRS knows of the problem, and the federal government is searching desperately for revenue. The practice of
temporary services firms improperly utilizing per diem is so historically prevalent, that the IRS Commissioner
published a paper in 1997, Per Diem Allowances for Temporary Technical Services Employees. (Hereafter, “IRS Per
Diem Paper.”) In 1997, the IRS stated:
“Employers in the construction, aerospace, defense contracting, nuclear power generation and other
similar industries fill many of their technical positions with ‘temporary’ employees provided by technical
services firms, also known as "job shops.’
***
An employer gives the employee a daily allowance of up to $50 to cover "travel expenses" associated
with the job assignment even though, in many cases, the employee resides in the vicinity of the job
assignment. The employer makes no attempt to verify that the employee qualifies for travel status
(being away from home overnight) and there is no requirement that the employee account back to the
employer for funds expended. The employer does not include the daily allowance in the employee’s
income, does not report it on Form W-2, and does not classify it as wages for employment tax purposes.”
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In the Obama era, federal agencies have been allocated enforcement budgets unseen during the Bush
administration.1 They are increasing audits that will generate fines and penalties to replace tax revenue, declining
as a result of the recession and the personal and business bankruptcies that have followed. Most professionals who
deal with government agencies will attest to a spike in enforcement activity. How long will it be before the IRS
audits staffing companies on their per diem practices, especially given the historical record of abuse? The missed
tax revenue and potential penalties are simply too enticing to be ignored.
“Harder to Catch” Isn’t The Same As “Lawful”
Companies playing loose with per diem are likely hoping a 2004 Internal Revenue Bulletin (2004-42) will shield
them if the IRS comes knocking. However, the Revenue Bulletin only does away with the need to obtain and
retain receipts for travel expenses.
The substantive requirements set forth by the statute (26 USC §162(a)(2)) and Internal Revenue Regulation (26
CFR 1.62-2(c)) remain the same as when the IRS Per Diem Paper was written. The foundational statute still limits
the deduction from income to “travelling expenses....while away from home in the pursuit of a trade or business.”
And Section 1.62-2(c)(1) still provides:
1.
Per Diem Compensation is only excludable from income (i.e., non-taxable) when
a. It has a “business connection:”
i. It reimburses for ordinary and necessary travel (lodging, meals, and incidental)
expenses;
ii. That are incurred (or that the employer reasonably expects to be incurred)
while away from home
iii. For a temporary assignment of less than one year
b.
The employee is required to return amounts exceeding the expenses within a
reasonable amount of time (which requirement is satisfied where the employee is paid
at a daily rate and the employee is required to return the amounts paid for days of
travel not substantiated).
The only effect of the 2004 reform is to automatically “deem substantiated” any travel expenses reimbursed at or
below published federal per diem rates. In other words, the need for receipts and accounting has been eased. 2
Some employers have run amok believing that the “deemed substantiated” process has eliminated the
foundational requirements of per diem compensation. However, Section 1.62-2(c)(1) still requires that payments
constitute reimbursement for travel expenses incurred or reasonably expected to be incurred while away from
home for a temporary assignment of less than one year.
1
According to Gannett’s The Federal Times, the Department of Labor obtained a $400 Million increase in
discretionary spending in 2010, permitting the department to hire approximately 1000 additional enforcement
officers. Similarly, the IRS has received a $400 Million increase in funds to collect unpaid taxes.
2 Internal Revenue Bulletin 2004-42 provided:
1. Actual “substantiation” of expenses incurred is no longer required; the amount provided to the employee is
“deemed substantiated” if the employer pays a per diem allowance that is equal to or less than the published
federal per diem rate for the locality of travel;
2. The employee need only substantiate the time, place and business purpose of the travel, and amounts at or
below the federal per diem rate are “deemed substantiated;”
3. The per diem allowance can be paid as a flat daily rate or in very rare instances (under grandfathered, preDecember, 1989 plans or industry practices) as an hourly payment or by the mile;
4. The requirement that the employee return amounts exceeding expenses is met if the employee is required
to return amounts attributable to unsubstantiated days of travel. (However, the employee need not return
the portion of the allowance not actually used on days of travel.)
2
The ongoing abuses take many forms:
“Commuting” or “No-Travel” Abuse of Per Diem
The practice noted in the Per Diem Paper (job shops were paying “travel expenses,” though the employee “lives
in the vicinity” of the assignment, and were making no attempt to verify whether the employee is away from
home overnight) is still going on. There is no argument that such payments are not taxable. The U.S. Supreme
Court has held that to qualify for Section 162 of the Internal Revenue Code, the taxpayer must be on a trip
requiring sleep or rest.” United States v Correll, 389 US 299 (1967).
Consistently, IRS Publication 463 defines “travel away from home:”
“You are traveling away from home if:
o Your duties require you to be away from the general area of your tax home substantially longer
than an ordinary day's work, and
o You need to sleep or rest to meet the demands of your work while away from home.”
Accordingly, though the employer need not substantiate that the employee actually incurred travel expenses with
receipts, per diem pay is improper where there is no “day of travel” requiring sleep or rest away from home.
Many governmental agencies’ policies assume that per diem pay is appropriate for employees traveling more
than 50 miles to an assignment. A private sector employer might, then, pay per diem when the employee is
commuting daily. There is no support for the practice in the official written materials. Revenue Ruling 75-432
said:
“Congress did not intend to allow as a business expense those outlays that are not caused by the
exigencies of the business but by the actions of the taxpayer in having a home, for the taxpayer’s
convenience, at a distance from the business.
***
The rule known as the ‘overnight rule’ or the ‘sleep and rest rule’ is used to determine whether an
employee…is considered to be in a travel status. An employee may deduct the expenses for meals and
lodging on a business trip away from the principal post of duty only when the trip lasts substantially
longer than an ordinary day’s work, the employee cannot reasonably be expected to make the trip
without being released from duty for sufficient time to obtain substantial sleep or rest while away from
the principal post of duty, and the release from duty is with the employer’s tacit or express
acquiescence, or is required by regulations of a governmental agency…”
“No-travel” per diem issues come up in three different scenarios:
o
o
o
The individual lives in the vicinity of the work location, but is provided per diem pay- There seems little
doubt but that this would be viewed as improper and could be framed as criminal tax evasion;
The individual commutes daily beyond fifty miles, but is provided a per diem allowance for meal, lodging
and incidentals- As noted above, this situation places the employer and employee at risk. Even if one
concludes that Internal Revenue Bulletin 2004-42 signified that IRS was officially “looking the other way” if
the employee chose to commute instead of taking up lodging near the employment, the current
administration and economic climate provide a motive to do an about-face.
The individual commuting is paid per diem for days not worked- This can occur where one is paid a weekly
per diem allowance without adjustment for absence from the assignment, such as where the per diem is paid
during vacation weeks. Such days would be unsubstantiated and not qualify as a day of travel.
“Temporary Assignment” Abuse of Per Diem
Per Diem allowances are only allowable for temporary assignments. The IRS Per Diem Paper makes the following
statement (with language relating to the employer’s subjective assessment in bold type):
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“Section 162 (a)(2) (as amended) provides that an employee shall not be treated as being temporarily
away from home during any period of employment exceeding one year…[I]f employment is realistically
expected to last (and does in fact last) for 1 year or less, the employment will be treated as temporary in
the absence of facts and circumstances indicating otherwise. If employment away from home in a single
location is realistically expected to last for more than 1 year or there is no realistic expectation that the
employment will last for 1 year or less, the employment will be treated as indefinite, regardless of
whether it actually exceeds 1 year. If employment away from home in a single location initially is
realistically expected to last for 1 year or less, but at some later date the employment is realistically
expected to exceed 1 year, the employment will be treated as temporary (in the absence of facts and
circumstances indicating otherwise) until the date the realistic expectation changed.”
The IRS makes determinations of whether an assignment is “temporary” on a case by case basis. Accordingly, if
an employer could articulate facts that would support a realistic expectation that the assignment will last for less
than a year, per diem compensation might be appropriate, despite an open-ended purchase order.3 However,
the one practice that will clearly not pass muster is broadly providing per diem pay to employees in their first
year of a longer assignment. This pattern, likely to be discovered in an audit, will provide evidence that the
employer provided per diem regardless of any realistic expectation that the assignment would last less than one
year.
Excessive Payment Abuses of Per Diem
Some employers believe that per diem rates are capped only on government projects, and that they are free to pay
higher non-taxable per diem on private sector work. They can pay higher rates if they keep receipts substantiating
the amount paid or if tax is paid. However, under Revenue Bulletin 2004-42, to qualify for the “deemed
substantiated” process, the per diem must be paid at or below the “federal per diem rate”
The “federal per diem rate” is the sum of lodging, meal and incidental expenses for locales in each state published
by the General Services Administration. The GSA rates are re-published in IRS Publication 1542, which provides this
guidance to the private sector: “This publication is for employers who pay a per diem allowance to employees for
business travel away from home...It gives the maximum per diem you can use without treating part of the per diem
allowance as wages for tax purposes.” Further making the point, courts cite the GSA rates in the cases against
private sector employers.
Calculating Overtime Based On Per Diem Compensation Abuse
A particular danger is presented when the employer calculates overtime pay upon combined hourly wages and the
per diem payment. Per diem is properly excluded from wages for purposes of calculating overtime. 29 CFR
778.217; Berry v Versus Excel Group, Inc., 288 F3d 252 (5th Cir., 2002). Only “payments...which are
disproportionately large or which obviously exceed the employee’s actual (or reasonably approximate) expenses”
need be included in the employee’s regular rate of pay. 1987 Wage Hour Opinion Letter, 1987 DOLWH LEXIS 56.
Questions immediately arise from including per diem in the overtime calculation: Why would an employer willingly
base overtime pay upon something that is not part of an employee’s regular rate of pay? Why blend taxable
overtime with non-taxable per diem payments?
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Such facts might entail:
 A realistic assessment of when the customer’s project will be completed, despite the indefinite purchase
order;
 Lack of funding beyond a certain calendar date, despite the indefinite P.O.
 An employee’s verifiable intention of working less than a year. In one case, the employee’s visa expired
in 6 months, and thus the assignment was considered temporary (until his visa was then extended). (Rev.
Rul. 73-578);
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One can expect the IRS to argue that the payment of overtime upon per diem is effectively an admission by the
employer that: 1) the per diem “obviously exceeds the employee’s actual or reasonably anticipated expenses;” or 2)
the per diem payment is a subterfuge to avoid payroll taxes.
Although cases have not arisen in this precise context, the IRS has previously based its arguments upon similar
blending of taxable wage and per diem payments. In Worldwide Labor Support of Miss., Inc. v. United States, 312
F.3d 712 (5th Cir., 2002), one of the rare instances where an hourly per diem payment was proper because of a
grandfathered industry practice, the government made two arguments that a per diem plan was outside § 1.62: a.)
employees were given either a 50 cent per hour raise in wages or per diem after two months on assignment
(demonstrating the per diem was merely a substitute for wages); and b.) the employer paid per hourly diem
payments on overtime hours, so that individuals with the same living expenses received different per diem
payments depending upon the hours worked. The employer in Worldwide prevailed only because of the nuances
inherent in the archaic hourly per diem rate. However, any employer not within a grandfathered “hourly” per diem
system would be vulnerable to the government’s argument.
Shotgun Deliveries, Inc. v United States, 269 F.3d 969 (9th Cir., 2001) shows how disguising wages as per diem results
in tax liability. There, the employer paid drivers 40% of the customer’s delivery charge for every package delivered,
broken down into two checks: a payment of minimum wage for every hour worked, and the remainder of the 40%
as per diem reimbursement for travel expenses. The Court ruled that the per diem payments were taxable because
the expense reimbursements bore no relation to actual expenses. A faster driver took home less in wages and more
in the reimbursement check, though their travel expenses were the same. Accordingly, there was no business
connection: “Rather, the evidence suggests that the plan’s primary purpose was to treat the least amount possible
of the drivers’ [compensation] as taxable wages.”
Expect the IRS to argue that basing overtime payments on per diem payments similarly increases the per diem
payments based upon hours worked without regard to actual travel expenses incurred. Also, note how including
per diem in the OT calculation will usually increase the per diem beyond GSA rates.
Hourly Payment of Per Diem
This paper cannot leave the subject of per diem in the staffing industry without touching upon the subject of
paying per diem as an hourly amount. In broad terms, paying an hourly per diem amount, like including per diem
in overtime, creates the appearance that the per diem amount is merely a disguised wage. 4 Yet, there is some
support for paying hourly per diem in limited circumstances.
Internal Revenue Bulletin 2004-42 provides conflicting statements about hourly per diem in immediate proximity to
each other. It states:
Section 3. Definitions, .03 Flat rate or stated schedule.
1.
[A]n allowance is paid at a flat rate or stated schedule if it is provided on a uniform basis with respect
to the expenses described in section 3.01 of this revenue procedure. The allowance may be paid with
respect to the number of days away from home in connection with the performance of services as an
4
The Dept. of Labor Field Operations Handbook states: “If the amount of per diem…is based upon and thus varies
with the number of hours worked per day or per week, such payments are part of the regular rate in their
entire[t]y.” Gagnon v United Technisource, Inc., 607 F.3d 1036 (5th Cir., 2010) held hourly per diem payments were
regular wages, includable in overtime, especially since he was given a “raise” in per diem pay, not in his wages.
Newman v Advanced Technology Innovation Corp., 2012 U.S. Dist. LEXIS 182233 (DC Mass., 2012) involved daily per
diem payments at the permitted GSA amount, which were reduced if the individual worked less than 40 hours. The
employer won the case because it paid a daily amount, not an hourly amount, and the Dept. of Labor Field
Operations Handbook permits payment of a prorated amount upon working a partial day.
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employee or on any other basis that is consistently applied and in accordance with reasonable
business practice. Thus, for example, an hourly payment to cover meal and incidental expenses paid
to a pilot or flight attendant who is travelling away from home…is an allowance paid at a flat rate or
stated schedule.
2.
Limitation. [A]n allowance that is computed on a basis similar to that used in computing the
employee’s wages…(such as hours worked…) does not meet the business connection requirement…is
not a per diem allowance and is not paid at a flat rate or stated schedule, unless, as of December 12,
1989, an allowance computed on that basis was commonly used in the industry in which the
employee is employed. (Emphasis added.)
The language in paragraph 2 regarding what I will call the “historical safe harbor” is taken verbatim from the federal
regulation, 26 CFR § 1.62-2 (d)(3)(ii). The example in paragraph 1 of an “hourly payment” of per diem to a pilot as a
flat rate or stated schedule is not found in the regulations, but only in Internal Revenue Bulletin 2004-42.
Attempting to reconcile the seemingly disparate messages, the airline pilot example would be consistent with ¶ 2 if
the “hourly payment” made to the pilot was based on hours away from home, not hours worked. For example, a
pilot may be away from home for 60 straight hours (2.5 days), but only work 16 hours during that time. It would be
logical to pay per diem based on hours/partial days away from home because he/she would be incurring meal and
lodging expense.
The other possible source for justification for hourly per diem is found in the case of Worldwide Labor Support of
Mississippi, Inc. v United States, 312 F3d 712 (5th Cir., 2002). Citing the “historical safe harbor” exception in
paragraph 2, above, the court noted that:
“[T]here is no dispute in this case that it was the custom in Wordwide’s industry –the skilled temporary
labor industry – on December 12, 1989 to use hourly per diem travel reimbursement arrangements.”
312 F3d at 716.
This statement is intriguing but presents a factual dilemma in real life. There is no principle of law that the
temporary labor industry is grandfathered. The quoted statement means that in 2002, Worldwide had identified a
person who could provide testimony to the effect that it was the custom to pay hourly per diem in the temporary
skilled labor industry on December 12, 1989, and that the government had no counter-witness to dispute that.
Because of that, the analysis moved on from whether the employer automatically lost the case because per diem
was paid hourly to other arguments.
The author is extremely pessimistic about being able to produce proofs on the “historical safe harbor,” despite
representing staffing company clients since 1990. Locating individuals with knowledge about industry-wide
practices 24 years after the crucial date could be nearly impossible. However, if crucial to the defense of a
matter, perhaps the ASA could provide such expertise.
Policing and Reporting Violations
Companies playing fast and loose with per diem are likely secure in the belief that neither they nor the employee
have any motive to bring the underpayment of tax to light. However, this scenario could come to the attention of
the IRS in other ways. The IRS has a mechanism for reporting suspected tax fraud. Any party, including any of
those losing out to companies violating per diem rules may anonymously report suspected “unreported income”
on IRS form 3949-A and obtain a reward if tax is recovered.
Even employees participating in the scheme may develop a motive to expose their employer. An employee
audited by the IRS and forced to pay back tax and penalties, could then easily claim that he/she was assured that
the income would be provided tax free, and seek reimbursement of the tax and penalty from the employer. That
claim could be cast as a class action, thus bringing every per diem payment arrangement into issue.
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Beyond that, employees often become whistleblowers if they suspect that termination is coming. A company
violating per diem rules has armed many of its employees with knowledge of wrongdoing so they may become a
whistleblower.
The Dangers Of Being Outside § 1.62-2(c)(1)
The primary danger of not following the Tax Code is that per diem payments become taxable. However, this is not
just the employee’s problem. Obviously, the employer will not have withheld the necessary income tax, FICA, FUTA
and Medicare tax. Federal statutes, including 26 USC 6672, make the employer liable for all tax payments not
withheld and paid over.5 And, this liability can extend to individuals, such as the president of the organization. Baily
v. United States, 355 F. Supp. 325 (ED PA, 1973).
If the failure is deemed to be willful, criminal liability can result against corporations and individuals. 26 USC §7202.
The penalty can be a $10,000 fine and five years imprisonment.
The best result one could expect upon a finding that per diem payments were improper is that only the portion of
payments exceeding the GSA rates would be taxable. IRS Publication 1542 states that it “gives the maximum per
diem you can use without treating part of the per diem allowance as wages.” However, this least painful result
occurs only when the employer has all other ducks in a row. 1.62-2(h)(2)(i)(B) provides:
“If a payor pays a per diem...allowance under an arrangement that meets the requirements of the
paragraphs (d), (e) and (f) of this section [business connection, substantiation, returning amounts in
excess of expenses], the portion, if any, of the allowance paid...that exceeds the amount of the
employee’s expenses deemed substantiated...is treated as paid under a nonaccountable plan [and is
thus taxable].” (italics and bold type added)
The problem is in the italicized language quoted above. The IRS will argue that per diem payments that bear no
relationship to actual expenses do not have a business connection and thus don’t meet paragraph (d). The Ninth
Circuit stated in the Shotgun Deliveries case: “[I]f any reimbursements fail th[e] business connection test, the
entire scheme is invalidated and ‘all amounts paid under the arrangement are treated as paid under a
nonaccountable plan.’” This is the result required by 26 CFR § 1.62-2(d)(3), which states:
“If a payor arranges to pay an amount to an employee regardless of whether the employee incurs (or is
reasonably expected to incur) business expenses of a type described...the arrangement does not satisfy
this paragraph...and all amounts paid under the arrangement are treated as paid under a
nonaccountable plan.”
The liability can be significant. In Worldwide Labor Support, the IRS sought more than $2 Million. Shotgun
Deliveries resulted in a judgment of $615,290 where just 12-15 employees were paid per diem.
Bill Pilchak is a shareholder of Pilchak Cohen & Tice, P.C., a Metro-Detroit labor and employment law firm, serving
many staffing/vendor management companies and a member of the Worklaw® Network and the American
Staffing Association. Listed in “Best Lawyers in America” and nominated as an employment-litigation
“SuperLawyer” by Law and Politics Magazine, Mr. Pilchak’s article on non-compete agreements for temporary
staff was selected as the best labor and employment article published by the American Bar Association’s The
Labor Lawyer law journal in 2006.
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“Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully
fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to
evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be
liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid
over.”
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