IRS proposed regulations under section 274 issued 2/26/20.
The Tax Cuts and Jobs Act (TCJA) eliminated the deduction for entertainment expenses paid or incurred after Dec. 31, 2017 and separately, reduced the deduction for some food or beverage costs. On Feb. 22, 2020, the Internal Revenue Service (IRS) released proposed regulations that clarify the type of activity generally considered to be ‘entertainment’ and also, address the deductibility of food and beverage expenses. See Fed. Reg. 85, 11020 (Feb. 26, 2020). The proposed regulations build on the guidance provided in IRS Notice 2018-76 (Oct. 3, 2018) (Notice). The proposed regulations provide two new sections for TCJA changes, Reg. section 1.274-11 for entertainment expenses and Reg. section 1.274-12 for food or beverage expenses. The original regulations under section 274 stay in place for use with expenses incurred before the 2018 effective dates.
Under the proposed regulations, ‘entertainment’ expenses are defined as:
any activity which is of a type generally considered to constitute entertainment, amusement or recreation, such as entertaining at bars, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips including such activity relating solely to the tax payer or the taxpayer’s family.
Entertainment activities are determined under an objective test, and without regard to whether the expenditure is related to the active conduct of the taxpayer’s trade or business.
Food and beverages expenses provided at an entertainment activity may be counted as non-deductible entertainment. However, if the food or beverages are purchased separately from the entertainment or the cost of the food or beverages is stated separately from the cost of the entertainment on bills, invoices or receipts, the cost of the food and beverages is 50% deductible. The expenses broken out must reflect the venue’s usual selling cost for the items or must approximate the reasonable value of the items. In general, food and beverage expenses include all food and beverage items, regardless of whether characterized as meals, snacks or other types of food and beverages, regardless of whether or not the costs are de minimis fringes under section 132(e). The costs of food and beverages include the delivery fees, tips and sales tax.
As in the Notice, the example of expenses of taking a business associate to a baseball game is non-deductible entertainment, but the food and beverages are still 50% deductible if broken out on the invoice from the cost of tickets and related entertainment costs and reflect the costs of the food and beverages sold at the ballpark.
These rules also apply to the independent contractors for advances, allowances or reimbursement from the taxpayer client or customer for expenses paid by the independent contractor, provided that the parties have written agreement in place that states that the taxpayer client or customer will reimburse the independent contractor for food and beverage expenses, or specifically identifies which party will pay such amounts.
Food and beverage expenses
To be deductible, expenses for food and beverages must satisfy the following conditions:
- the expense is an ordinary and necessary expense under section 162(a) paid or incurred in carrying on any trade or business;
- the expense is not lavish or extravagant under the circumstances;
- the taxpayer or its employee is present at the furnishing of the food or beverages; and
- the food and beverages are provided to a current or potential business customer, client, consultant or similar business contact.
As a general rule, most food and beverage expenses are 50% deductible.
For this purpose, the proposed regulations define a ‘business associate’ as a person with whom the taxpayer could reasonably be expected to engage or deal in an active conduct of the business, such as the taxpayer’s customer, client, supplier, employee, agent, partner or professional adviser, whether established or prospective. For example, the food and beverage expenses incurred by a taxpayer who takes a client out to lunch to discuss the taxpayer’s trade or business activities are 50% deductible, as are the expenses of taking an employee to lunch to discuss a performance review.
Expenses for travel meals paid or incurred while traveling from home in pursuit of a trade or business are 50% deductible if they satisfy both the requirements listed above and comply with the employer’s substantiation requirements. However, travel meal expenses of a spouse, dependent or others are not deductible, except for certain members of the US Armed Forces, unless the spouse or a dependent is an employee, the travel has a bona fide business purpose, and the amounts would otherwise be deductible by the spouse, dependent or other person.
Exceptions under section 274(e).
The proposed regulations confirm that the nine exceptions to section 274’s deduction rules continue to apply to otherwise non-deductible entertainment expenses.
Pursuant to section 274(n)(1), only certain of the section 274(e) exceptions provide a 100% deduction for food and beverage expenses. The remaining section 274(e) categories permit only a 50% deduction for food or beverages. The exceptions that provide a 100% deduction for food and beverages are sections 274(e)(2), (3), (4), (7), (8) and (9) below.
100% deduction for both meals and entertainment expenses
(e)(2) - Food and beverage expenses included in the employee’s taxable income are generally 100% deductible, provided that the employee’s income tax return as originally filed, reflects the compensation as taxable, and these taxable wages were subject to timely payroll withholding under chapter 24 of the Code.
For example, an employer provides non de minimis food and beverages to its employees without charge at a company cafeteria on the employer’s premises. If the employer includes the fair market value of the cafeteria meals in the employee’s taxable income, the employer may deduct 100% of the expenses. The amount includible as compensation is the excess of the fair market value of the food and beverages, over the amount, if any, the employee paid for the food and beverages. The new proposed regulations note that if the employer includes a lower value in taxable compensation (that is, not equal to at least the amount required to be included in employee taxable compensation under Reg. section 1.61-21), the meals will not be treated as included in compensation, and this exception will not apply.
(e)(3) - Reimbursements to employees pursuant to a business reimbursement policy. This exception is essentially unchanged by the proposed regulations. Where an employee or contractor incurs food or beverage expenses while performing services to another person (such as a customer), under a reimbursement or expense allowance arrangement, the employee or contractor provides substantiation satisfying section 274(d) of the food or beverage expenses, and the employee or contractor is reimbursed for the costs. Either the employer or the customer will have a 50% loss of deduction under section 274, but not both.
(e)(4) - Recreational, social or similar activities provided primarily for the benefit of employees (other than highly compensated employees or owners). This major exception is generally used to provide a 100% deduction for the cost of holiday parties, retirement celebrations and other events that are primarily for employees and do not discriminate in favor of highly compensated employees. The proposed regulations’ examples provide additional clarity with respect to this broad exception and draws a distinction between a social event and a meal provided to employees not intended to be a social or recreational event. This is true even where the employees may socialize during the meal.
- The exception allows a deduction of 100% of the cost of a holiday party to which all employees are invited held in a hotel ballroom and including a buffet dinner and an open bar. If the party is limited to only highly-compensated employees, the exception does not apply.
- The exception also does not apply to expenses for food and beverages provided to hospital emergency personnel required to work through meal periods, even where the employer treats the value of the meals as excluded from income under section 119 (meals provided for the convenience of the employer). The food and beverages are not covered by the exception, even if the employees socialize, because the meals are provided for the employer’s convenience rather than as a social event for employees. Therefore, these amounts are 50% deductible.
- In another example, the proposed regulations provide that an employer provides free coffee, soda, bottled water, chips, donuts and other snacks in a break room available to all employees. The food and beverages provided are subject to the 50% deduction limit because the break room is not a recreational, social or similar activity primarily for the benefit of employees.
- Another clarifying example involves an employer who invites an employee and a client to dinner at a restaurant. Because it is the employee’s birthday, the employer orders a special dessert in celebration. The meal is a business meal and not an entertainment primarily for the benefit of the employee, even though the employee social activity is the form a birthday party. Thus, the food and beverage expenses are 50% deductible.
(e)(7) - Items available to the general public. The proposed regulations address this section and add several examples. For items that satisfy the ‘general public’ exception, the food and beverage expense are 100% deductible. The proposed regulations provide that the general public includes but is not limited to customers, clients and visitors, but does not include employees, partners or independent contractors of the taxpayer. Under the proposed regulation, this exception applies if over 50% of the food and beverages at a public event are primarily consumed by the general public. If 50% or less is consumed by the general public, only that portion which is consumed by the general public is 100% deductible.
- For example, the fees for breakfast and lunch at a summer camp open to the general public include the meal expenses for the campers, as well as for the camp counselors. The children consume more than 50% of the food and beverages, so the exception applies and 100% of the expenses are deductible.
- In another example, a real estate agent provides refreshments at an open house. The refreshments are provided to prospective customers but are also consumed by the agent’s employees. If more than 50% of the refreshments are consumed the prospective customers and other real estate agents (all members of the general public), the amounts are 100% deductible. If the food and beverages are primarily consumed by the employees, only the costs of food provided to the general public are subject to the 100% deduction.
(e)(8) - Goods or services (including the use of facilities) which are sold by the taxpayer in a bona fide transaction for an adequate and full consideration in money or money’s worth. Money or money’s worth in this instance does not include payment for services provided. Importantly, the new regulations provide examples addressing the restaurant industry. For example, an employer operates a restaurant, and provides food and beverages to customers but also to its food service employees before, during and after their shifts for no consideration. The costs of the food and beverages provided to the food service employees are 100% deductible because the restaurant sells food and beverages to customers in a bona fide transaction for adequate and full consideration in money.
(e)(9) - Expenses includible in the income of persons who are not employees. The proposed regulations provide that the 100% deduction applies only if the amount is includible in the gross income of the recipient.
100% deduction for entertainment only (not meals)
(e)(1) - Food and beverages furnished on business premises primarily for employees. The 50% deduction limit applies to most meals and beverages furnished on the employer’s premises.
(e)(5) - Business meetings of employees, stockholders, agents or directors. As noted above, these food and beverage expenses are 50% deductible pursuant to section 274(n)(1).
(e)(6) - Attendance at a business meeting or convention of a 501(c)(6) organization, including for example, business leagues, chambers of commerce, real estate boards, boards of trade, and organizations exempt from taxation under section 501(a). This rule generally remains the same. As above, food and beverage expenses at such events are still 50% deductible.
The proposed regulations apply for years after they become final. In the meantime, taxpayers may rely on the proposed regulations and Notice 2018-76.