Proposed Regs Address Deductibility of Entertainment and Food or Beverage Expenses

(Parker Tax Publishing February 2020)

The IRS issued proposed regulations which (1) address the elimination of the deduction under Code Sec. 274 for expenditures relating to entertainment, amusement, or recreation activities, and (2) provide guidance for determining whether an activity is of a type generally considered to be entertainment. Taxpayers may rely on the proposed regulations, as well as the guidance in Notice 2018-76, prior to the issuance of final regulations. REG-100814-19.

Background

In general, Code Sec. 274 limits or disallows deductions for certain meal and entertainment expenditures that otherwise would be allowable as an ordinary and necessary trade or business expense. Code Sec. 274 was amended by the Tax Cuts and Jobs Act (TCJA) to revise the rules for deducting expenditures for meals and entertainment, effective for amounts paid or incurred after December 31, 2017. Under Code Sec. 274(n)(1), the deduction for food or beverage expenses generally is limited to 50 percent of the amount that would otherwise be allowable. Prior to the TCJA, under Code Sec. 274(n)(2)(B), expenses for food or beverages that were excludable from employee income as de minimis fringe benefits under Code Sec. 132(e) were not subject to the 50 percent deduction limitation under Code Sec. 274(n)(1) and could be fully deducted. The TCJA repealed Code Sec. 274(n)(2)(B) so that expenses for food or beverages excludable from employee income under Code Sec. 132(e) are subject to the Code Sec. 274(n)(1) deduction limitation unless another exception under Code Sec. 274(n)(2) applies.

Under Code Sec. 274(k)(1), in order for food or beverage expenses to be deductible the food or beverages must not be lavish or extravagant under the circumstances and the taxpayer or an employee of the taxpayer must be present at the furnishing of the food or beverages. However, under Code Sec. 274(e)(2), (3), (4), (7), (8), and (9), there are six exceptions to the limitations on the deduction of food or beverages in Code Sec. 274(k)(1) and Code Sec. 274(n)(1) and the proposed regulations explain how those exceptions apply.

Code Sec. 274(a)(1)(A) generally disallows a deduction for any item with respect to an activity of a type considered to constitute entertainment, amusement, or recreation (entertainment expenditures). However, before the amendment by the TCJA, Code Sec. 274(a)(1)(A) provided exceptions to that disallowance if the taxpayer established that: (1) the item was directly related to the active conduct of the taxpayer's trade or business (directly related exception), or (2) 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), the item was associated with the active conduct of the taxpayer's trade or business (business discussion exception). Code Sec. 274(e)(1) through (9) also provides exceptions to the rule in Code Sec. 274(a) that disallows a deduction for entertainment expenditures. The TCJA did not change the application of the Code Sec. 274(e) exceptions to entertainment expenditures.

Code Sec. 274(a)(1)(B) disallows a deduction for any item with respect to a facility used in connection with an activity referred to in Code Sec. 274(a)(1)(A). Code Sec. 274(a)(2) provides that, for purposes of applying Code Sec. 274(a)(1), dues or fees to any social, athletic, or sporting club or organization shall be treated as items with respect to facilities. Code Sec. 274(a)(3) disallows a deduction for amounts paid or incurred for membership in any club organized for business, pleasure, recreation, or other social purpose.

Before amendment by the TCJA, Code Sec. 274(n)(1) generally limited the deduction of food or beverage expenses and entertainment expenditures to 50 percent of the amount that otherwise would have been allowable. Thus, under prior law, taxpayers could deduct 50 percent of meal expenses and 50 percent of entertainment expenditures that met the directly related or business discussion exception. Distinguishing between meal expenses and entertainment expenditures was unnecessary for purposes of the 50 percent limitation. TCJA repealed the directly related and business discussion exceptions to the general prohibition on deducting entertainment expenditures in Code Sec. 274(a)(1)(A). Also, the TCJA amended the 50 percent limitation in Code Sec. 274(n)(1) to remove the reference to entertainment expenditures. Thus, entertainment expenditures are no longer deductible unless one of the nine exceptions to Code Sec. 274(a) in Code Sec. 274(e) applies.

While the TCJA eliminated the deduction for entertainment expenses, Congress did not amend the provisions relating to the deductibility of business meals. Thus, taxpayers generally may continue to deduct 50 percent of the food and beverage expenses associated with operating their trade or business, including meals consumed by employees on work travel. However, as before the TCJA, no deduction is allowed for the expense of any food or beverages unless (1) the expense is not lavish or extravagant under the circumstances, and (2) the taxpayer (or an employee of the taxpayer) is present at the furnishing of the food or beverages.

Before amendment by the TCJA, Code Sec. 274(d) provided substantiation requirements for deductions under Code Sec. 162 or Code Sec. 212 for any traveling expense (including meals and lodging while away from home), and for any item with respect to an activity of a type considered to constitute entertainment, amusement, or recreation or with respect to a facility used in connection with such activity. TCJA repealed the substantiation requirements for entertainment expenditures. Traveling expenses (including meals and lodging while away from home), however, remain subject to the Code Sec. 274(d) substantiation requirements. Food and beverage expenses are subject to the substantiation requirements under Code Sec. 162 and the requirement to maintain books and records under Code Sec. 6001.

Notice 2018-76 provides transitional guidance on the deductibility of expenses for certain business meals. In the notice, the IRS requested comments for future guidance to further clarify the treatment of business meal expenses and entertainment expenditures under Code Sec. 274. Under Notice 2018-76, taxpayers may deduct 50 percent of an otherwise allowable business meal expense if:

(1) the expense is an ordinary and necessary expense under Code Sec. 162(a) paid or incurred during the tax year in carrying on any trade or business;

(2) the expense is not lavish or extravagant under the circumstances;

(3) the taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages;

(4) the food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact; and

(5) in the case of food and beverages provided during or at an entertainment activity, the food and beverages are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts.

The notice provides that the entertainment disallowance rule may not be circumvented through inflating the amount charged for food and beverages.

Proposed Regulations

The IRS has now issued proposed regulations which describe and clarify the statutory requirements of Code Sec. 274(a), Code Sec. 274(k), and Code Sec. 274(n), as well as the applicability of certain exceptions under Code Sec. 274(e) to food or beverage expenses. To implement the TCJA's disallowance of entertainment expenditures under Code Sec. 274(a), the proposed regulations have added Reg. Sec. 1.274-11 (Prop. Reg. Sec. 1.274-11) for entertainment expenditures paid or incurred after December 31, 2017. The proposed regulations also added Reg. Sec. 1.274-12 (Prop. Reg. Sec. 1.274-12) to address food or beverage expenses under Code Sec. 274(k) and Code Sec. 274(n) paid or incurred after December 31, 2017, including the application of the exceptions in Code Sec. 274(e)(2), (3), (4), (7), (8), and (9). Specifically, Prop. Reg. Sec. 1.274-12 addresses expenses for business meals as described in Notice 2018-76, as well as expenses for other meals including travel meals and employer-provided meals.

With respect to the requirement that the entertainment disallowance rule may not be circumvented by inflating the amount charged for food and beverages, the proposed regulations provide that the amount charged for food or beverages on a bill, invoice, or receipt must reflect the venue's usual selling cost for those items if they were to be purchased separately from the entertainment, or must approximate the reasonable value of those items. Further, the proposed regulations provide that unless food or beverages provided at or during an entertainment activity 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, no allocation can be made and the entire amount is a nondeductible entertainment expenditure.

With respect to the repeal of the "directly related" and "business discussion" exceptions to the general disallowance rule for entertainment expenditures, the proposed regulations clarify that the entertainment disallowance rule applies whether or not the expenditure for the activity is related to or associated with the active conduct of the taxpayer's trade or business.

The proposed regulations also address the general requirement in Notice 2018-76 that the food and beverages be provided to a business contact, which was described in the notice as a "current or potential business customer, client, consultant, or similar business contact." In response to a question on the definition of "potential business contact," the proposed regulations follow the definition of "business associate" as currently provided in Reg. Sec. 1.274-2(b)(2)(iii). Thus, the proposed regulations provide that the food or beverages must be provided to 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." In addition to clarifying this definition for purposes of determining whether a business meal expense is deductible, the proposed regulations apply this standard to the deduction of food or beverage expenses generally. In particular, the proposed regulations include employees as a type of business associate, making the standard applicable to employer-provided meals as well as to situations in which a taxpayer provides meals to both employees and non-employee business associates at the same event. Finally, the proposed regulations apply the limitations in Code Sec. 274(m)(3) to expenses for food or beverages paid or incurred while on travel for spouses, dependents or other individuals accompanying the taxpayer (or an officer or employee of the taxpayer) on business travel. The IRS noted that these limitations do not apply to deductions for moving expenses under Code Sec. 217.

In the proposed regulations, the IRS addresses several scenarios involving the deductibility of food or beverage expenses such as situations relating to the deductibility of expenses for:

(1) food or beverages provided to food service workers who consume the food or beverages while working in a restaurant or catering business;

(2) snacks available to employees in a pantry, break room, or copy room;

(3) refreshments provided by a real estate agent at an open house;

(4) food or beverages provided by a seasonal camp to camp counselors;

(5) food or beverages provided to employees at a company cafeteria; and

(6) food or beverages provided at company holiday parties and picnics.

The proposed regulations provide that the deduction limitation rules generally apply to all food and beverages, whether characterized as meals, snacks, or other types of food or beverage items. In addition, unless one of the six exceptions under Code Sec. 274(n)(2)(A) applies, the deduction limitations apply regardless of whether the food or beverages are treated as de minimis fringe benefits under Code Sec. 132(e).

Effective Date

Pending the issuance of the final regulations, a taxpayer may rely on the proposed regulations for entertainment expenditures and food or beverage expenses, as applicable, paid or incurred after December 31, 2017. In addition, a taxpayer may rely on the guidance in Notice 2018-76 until the proposed regulations are finalized.

For a discussion of the deductibility of travel, meal, entertainment expenses, see Parker Tax ¶91,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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