IRS Finalizes Regs on Deductibility of Entertainment and Food or Beverage Expenses

(Parker Tax Publishing October 2020)

The IRS issued final regulations that provide guidance under Code Sec. 274 regarding the elimination by the Tax Cuts and Jobs Act (TCJA) of the deduction for expenditures related to entertainment, amusement, or recreation activities, and provide guidance for determining whether an activity is of a type generally considered to be entertainment. The final regulations also address the limitation enacted by the TCJA on the deduction of food and beverage expenses under Code Sec. 274(k) and Code Sec. 274(n), including the applicability of the exceptions under Code Sec. 274(e)(2), (3), (4), (7), (8), and (9). T.D. 9925.

Background

In general, Code Sec. 274 limits or disallows deductions for certain meal and entertainment expenditures that otherwise would be allowable as ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. Code Sec. 274 was amended by the Tax Cuts and Jobs Act (TCJA) to limit the deductibility of certain meal and entertainment expenditures, effective for amounts paid or incurred after December 31, 2017.

Expenses for Food or Beverages

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 The TCJA repealed Code Sec. 274(n)(2)(B) so that expenses for food or beverages excludable from employee income under Code Sec. 132(e) are subject to the Code Sec. 274(n)(1)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. Code Sec. 274(e)(2) applies to expenses for goods, services, and facilities to the extent that the expenses are treated as compensation to the recipient. Code Sec. 274(e)(3) applies to expenses incurred by a taxpayer in connection with the performance of services for an employer or other person under a reimbursement or other expense allowance arrangement. Code Sec. 274(e)(4) applies to expenses for recreational, social, or similar activities for employees. Code Sec. 274(e)(7) applies to expenses for goods, services, and facilities made available to the general public. Code Sec. 274(e)(8) applies to expenses for goods or services that are sold by the taxpayer in a bona fide transaction for an adequate and full consideration in money or money's worth. Code Sec. 274(e)(9) applies to expenses for goods, services, and facilities to the extent that the expenses are treated as income to a person other than an employee.

Entertainment Expenses

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 and Proposed Regulations

In October of 2018, the IRS issued Notice 2018-76 to provide transitional guidance on the deductibility of expenses for certain business meals and requested comments for future guidance to further clarify the treatment of business meal expenses and entertainment expenditures under Code Sec. 274. Under the notice, 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 at or during 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. Notice 2018-76 provides that the entertainment disallowance rule may not be circumvented through inflating the amount charged for food and beverages.

In February of 2020, the IRS issued proposed regulations (REG-100814-19) to implement the TCJA amendments to Code Sec. 274 by adding (1) Prop. Reg. Sec. 1.274-11 for entertainment expenditures, and (2) Prop. Reg. Sec. 1.274-12 to address the limitations on food or beverage expenses under Code Sec. 274(k) and Code Sec. 274(n), including the application of the exceptions in Code Sec. 274(e)(2), (3), (4), (7), (8), and (9). Pending issuance of the final regulations, taxpayers were permitted to rely on the proposed regulations for entertainment and food or beverage expenses paid or incurred after December 31, 2017.

Final Regulations

Last week, the IRS finalized the proposed regulations in T.D. 9925. The final regulations adopt the proposed regulations with certain modifications in response to practitioners' comments.

The IRS received several comments relating to the exceptions to the general disallowance rule for expenses treated as employee compensation under Code Sec. 274(e)(2) or expenses relating to non-employees in Code Sec. 274(e)(9). The IRS noted that these exceptions have been interpreted by some as allowing a taxpayer to deduct the full amount of an expense if the expense has properly been included in the compensation and wages of the employee, or gross income of the recipient, even if the amount of the expense exceeds the amount included in compensation or income. Thus, the IRS said, some taxpayers may attempt to claim a full deduction under one of these exceptions by including a value that is less than the amount required to be included under Reg. Sec. 1.61-21 (which provides the rules for valuation of fringe benefits), or by purportedly including a value of zero, as compensation and wages to the employee, or as includible in gross income by a person who is not an employee of the taxpayer. As a result, Prop. Reg. Sec. 1.274-12(c)(2)(i) provided that expenses for food or beverages for which the taxpayer calculates a value that is less than the amount required to be included in gross income under Reg. Sec. 1.61-21, or for which the amount required to be included in gross income is zero, would not be considered as having been treated as compensation and as wages to the employee, or as includible in gross income by a non-employee recipient of the food or beverages, for purposes of Code Sec. 274(e)(2) and Code Sec. 274(e)(9).

Practitioners argued that this proposed rule was unduly harsh, given the difficulty in determining the value of food or beverages under Reg. Sec. 1.61-21 and the possibility of good faith errors. In the preamble to the final regulations, the IRS said it agreed that the "all or nothing" rule in the proposed regulations could lead to unduly harsh results. Therefore, the final regulations allow a taxpayer to apply Code Sec. 274(e)(2) and Code Sec. 274(e)(9) in cases where the taxpayer includes an improper amount in compensation and wages, or gross income, of the recipient. However, under the final regulations, if a taxpayer includes less than the proper amount in compensation and wages or gross income, the taxpayer must apply the "dollar-for-dollar" methodology that applies to specified individuals under Code Sec. 274(e)(2)(B). Under the dollar-for-dollar methodology, the taxpayer may deduct meal expenses to the extent that the expenses do not exceed the amount of the expenses that are treated as compensation and wages, or gross income, as applicable.

A practitioner also commented on the effect of reimbursements by employees or other recipients of the food or beverages on the amount excepted from the limitations under Code Sec. 274(k)(1) and Code Sec. 274(n)(1) by Code Sec. 274(e)(2) and Code Sec. 274(e)(9). The practitioner explained that for specified individuals, Reg. Sec. 1.274-10(a)(2)(ii)(C)(2) treats reimbursements in the same manner as compensation and wages, and argued that a similar rule should be provided for reimbursements from non-specified individuals. The IRS agreed that in cases in which expenditures for food and beverages are reimbursed to the taxpayer, similar treatment should be provided under Code Sec. 274, regardless of whether the food or beverages are provided to a specified or non-specified individual. Therefore, with regard to non-specified individuals, the final regulations provide that a taxpayer may deduct its food or beverage expenses under the exception in Code Sec. 274(e)(2)(A) or Code Sec. 274(e)(9) if the taxpayer includes the proper amount in compensation and wages, or gross income, as applicable. Reg. Sec. 1.61-21(b)(1) requires that an employee must include in gross income the amount by which the fair market value of the fringe benefit exceeds the sum of (1) the amount paid for the benefit by or on behalf of the recipient and (2) the amount, if any, specifically excluded from gross income under the Code. Thus, the amount of the reimbursement is taken into account in determining the amount properly includible in the recipient's income and does not affect the taxpayer's ability to use the exception in Code Sec. 274(e)(2)(A) or Code Sec. 274(e)(9). Further, with regard to improper inclusions in compensation and wages or gross income, the final regulations provide that the taxpayer must apply the same dollar-for-dollar methodology that applies to specified individuals under Code Sec. 274(e)(2)(B).

Example: An employer provides food and beverages to its non-specified individual employees without charge at a company cafeteria on its premises. The food and beverages do not meet the definition of a de minimis fringe under Code Sec. 132(e). Thus, the employer treats the full fair market value of the food and beverage expenses as compensation and wages, and properly determines this amount under Reg Sec. 1.61-21. Under Code Sec. 274(e)(2) and Reg. Sec. 1.274-12(c)(2)(i)(A) of the final regulations, the food and beverage expenses are not subject to the 50 percent deduction limitation.

Example: The facts are the same as in the above example, except that each employee pays $8 per day for the food and beverages. The fair market value of the food and beverages is $10 per day, per employee. The employer incurs $9 per day, per employee for the food and beverages. The employer treats the food and beverage expenses as compensation and wages, and properly determines the amount of the inclusion under Reg. Sec. 1.61-21 to be $2 per day, per employee ($10 fair market value - $8 reimbursed by the employee = $2). Therefore, under Reg. Sec. 1.274-12(c)(2)(i)(A), the employer may deduct 100 percent of the food and beverage expenses, or $9 per day, per employee.

In addition, the IRS stated that it continues to believe that if the amount to be included in compensation and wages or gross income is zero, whether zero is a proper or improper amount, the exceptions in Code Sec. 274(e)(2) and Code Sec. 274(e)(9) do not apply because no amount has been included in compensation and wages or gross income. For example, if the amount to be included is zero because the value of the food or beverages is excluded as a fringe benefit under Code Sec. 132, the exceptions in Code Sec. 274(e)(2) and Code Sec. 274(e)(9) do not apply. Similarly, these exceptions do not apply if the amount to be included is zero solely because the recipient has fully reimbursed the taxpayer for the food or beverages. In that case, however, the exception in Code Sec. 274(e)(8) may apply if the food or beverages are sold to the recipient in a bona fide transaction for an adequate and full consideration in money or money's worth.

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.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com