Two of the most common business expenses, and their related tax adjustments, are meals and entertainment expenses. Internal Revenue Code Section 274 governs the deductibility, and largely the disallowance, of certain meals and entertainment expenses and other miscellaneous expenses including gifts, travel, and club dues. In the context of a professional services entity, a significant portion of expenses are incurred in client development and client retention activities. Too often, these expenses are overlooked resulting in improper additions to taxable income or overstated deductions. Treasury has recently released final regulations under IRC §274 which remain largely unchanged from the proposed regulations issued earlier this year in February 2020.The final regulations serve to confirm the nine exceptions previously detailed under IRC §274 as to deductible treatment. The Regulations also serve to incorporate much of the guidance offered previously in IRS Notice 2018-76.
Under the Tax Cuts and Jobs Act (TCJA) of 2017, IRC §274(a) was amended in such a way that disallowed any business deduction with respect to an activity which is considered to constitute entertainment, amusement, or recreation and any related facility costs associated with said entertainment, amusement, or recreation. Previously, these expenses would have been deductible under two exceptions known as the “directly related” exception and the “business discussion” exception. Essentially, these exceptions were met if the expense was directly related to a trade or business (directly related) or if business was discussed before or after the entertainment event (business discussion). Gone are the days of running half the expense of those season tickets through other deductions on the tax return.
Now that entertainment and recreation costs are off the table, what now? It makes sense to take a deeper dive into IRC §274 and look at what might still qualify as a good deduction. In the scope of this article, our focus is on deductible meals. IRC §274(k) is where you’re going to find business meals and the exceptions that make these expenses deductible. The two factors to consider and defined in this section are that (1) the expense is not lavish or extravagant for the circumstances and (2) the taxpayer or someone employed by the taxpayer is present for the meal. A quick jump to IRC §274(n) provides that only 50% of the meal expense is permitted as a deduction. The 50% deduction for business meals isn’t new, but what’s now more important is that these expenses are properly tracked and bifurcated from their nondeductible entertainment expenses.
When the TCJA put entertainment expenses on the chopping block to make up for some of the revenue lost to other provisions there was a lot of grey area and interpretation as to what expenses, if any, were still deductible as meal expenses under IRC §274(k) and IRC §274(n). We now turn our attention to the final regulations under IRC §274, which built upon the interim guidance provided in IRS Notice 2018-76 and the proposed regulations under IRC §274. Specifically, we look to Final Regulations §1.274-11 and §1.274-12. We find that we can generally deduct our expenses related to meals (subject to the 50% limitation) if we meet the following criteria:
- The expense is not lavish or extravagant for the circumstances.
- The taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages.
- The food and beverages are provided to a “business associate.” A “business associate” in this context means a person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business such as the taxpayer’s customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective.
- Food or beverages are not included in the definition of entertainment if they are purchased separately from the entertainment, or the cost of the food or beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts.
It’s important to focus on the fourth criterion. If there are food or beverage expenses that are purchased separately or stated separately then these expenses can potentially be treated as deductible meal expenses (provided the other criteria are also satisfied). In order to meet these requirements the IRS requires the substantiation of these expenses. Specifically, IRC §274(d) requires that the taxpayer substantiates the amount of such expense, the time and place of the expense, the business purpose, and the business relationship to the taxpayer.
Final Regulations §1.274-12(c) also provides for exceptions to the 50% limitation on business meals resulting in 100% fully deductible treatment. One particular section of note provides for an exception for recreational expenses for employees. Food and beverage expenses that are provided for all employees and, do not discriminate in favor of highly compensated employees, are exempt from the application of IRC §274(a) and are fully deductible. Examples given in the final regulations for these recreational events include holiday parties, annual picnics, and company outings. There are several other exceptions under this section which could potentially result in a full deduction for food and beverage expenses. These exceptions should be evaluated on a case by case basis.
The next time you take that client or prospect out to an event you may want to take a second look at those food and beverage expenses. Good documentation can go a long way in reclaiming some of that seemingly lost benefit in “entertainment” expenses in the form of partially, or fully deductible food and beverage expenses. Please contact a Schneider Downs tax advisor if you would like to discuss these rules in greater detail.
