The deduction for meals and entertainment (M&E) expenses has been one of the most broadly applicable opportunities for significant tax savings; however, after tax reform, there are some misconceptions regarding how to apply the rules and what opportunities remain.
Under prior law, the Internal Revenue Code stated that a taxpayer could only deduct 50 percent of meals and entertainment expenses unless certain exceptions applied. Broadly defined, meals are food or beverages, and entertainment is "any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement or recreation, or with respect to a facility used in connection with such activity." These definitions were intentionally broad, and there were numerous exceptions to the general rule making certain meals and entertainment expenses 100 percent deductible.
However, the Tax Cuts and Jobs Act (TCJA) provided the most substantial overhaul of the U.S. tax code in decades and sought to further limit the deductibility of some meals and most entertainment expenses, but some important exceptions still apply. The deductibility of many popular employer-provided fringe benefits, such as deductions for work-related activities—including certain meal and entertainment expenses have undergone sweeping changes. Now more than ever, employers need to understand their M&E expenses and ensure they are properly categorized and deducted, to avoid lost tax savings.
What is gone and what remains?
The TCJA completely eliminates the employer tax deduction for substantially all directly paid or reimbursed business entertainment expenses. In the meantime, it may allow employers to deduct certain enumerated expenses listed as exceptions in section 274(e). Interestingly, the exceptions under sections 274(e)(5) and (e)(6) (regarding employee, stockholder and business league meetings) are now applicable to entertainment expenses as a result of how section 274(a) was reworded in the TCJA. Importantly, the law also retains most of the current section 274(n) exceptions to the 50 percent meals deduction disallowance.
There has been a lot of discussion in the tax community regarding the question of whether a business meal with a client should be treated as entertainment or as meals under the new law. We believe that business meals which (1) take place between a business owner or employee and a current or prospective client; (2) are furnished at a restaurant and not an entertainment venue (such as a nightclub, cocktail lounge or sports arena); (3) are not lavish or extravagant under the circumstances; and (4) where the taxpayer has a reasonable expectation of deriving income or other business benefit from the meeting, may continue to be treated as a 50 percent deductible meals expense. The IRS has told us that regulations will be issued to define “entertainment” more specifically; however, section 274 regulations are not on the IRS priority guidance plan that was recently released. So we are not expecting M&E regulations any time soon.
Under the rewrite of section 274:
- Typical business entertainment is 100 percent nondeductible for expenses paid or incurred after Dec. 31, 2017.
- The 50 percent limitation for business-related food and beverage expenses applies now to include food and beverages provided to employees through an eating facility, as well as other employer provided de minimis food and beverages at the workplace (such as coffee and donuts, working meals and overtime meals) unless they are served as part of an event that would fall under the employee recreation exception of section 274(e)(4).
The deduction for expenses associated with providing any qualified transportation fringe benefit, including for commuting between the employee’s residence and place of employment, would be disallowed, except as necessary for ensuring the safety of the employee.
Realizing the potential of the exceptions
Companies should now review the tax treatment of their M&E expenses to realize the exceptions to the limitation rules to identify expenses that should be treated as 100 percent deductible, as well as to comply with the changes of certain expenses to nondeductible or 50 percent deductible. Under current law, companies can review current and open tax years to take advantage of favorable M&E tax rules as well as higher rates for tax savings. A review like this now will help companies better understand their chart of accounts, process and expense reporting system which will make implementation of the new M&E rules much more efficient.
It is clear employers will be required to make changes to their systems and processes at this time. Companies should review the tax treatment of their M&E expenses to realize the exceptions to the limitation rules to identify expenses that should be treated as 100 percent deductible. These examples of fully deductible expenses include:
- Expenses treated as employee compensation
- Reimbursed expenses
- Expenses for recreational, social or similar activities primarily for the benefit of employees
- Expenses for goods, services and facilities made available by the taxpayer to the general public
- Expenses for goods or services which are sold by the taxpayer in a bona fide transaction for an adequate and full consideration
- Expenses includable in income of persons who are not employees
Whether considering the tax treatment of M&E expenses for 2017, or evaluating how tax reform will affect your deductions, statistical sampling is an effective and efficient way to understand your tax position and recognize savings. Companies may efficiently increase earnings per share, decrease their effective tax rate and increase cash by incorporating these rules into their accounting policies and may nonintrusively segregate nondeductible or 50 percent deductible expenses from 100 percent deductible expenses to help minimize income taxes.
