As many taxpayers progress through their first filing deadlines of the new decade, the IRS recently released proposed regulations (REG-100814-19, effective for taxable years beginning after December 31, 2017) providing additional meals and entertainment (“M&E”) guidance regarding M&E changes contained within the 2017 Tax Cuts and Jobs Act (“TCJA”, “the Act”).  The proposed regulations contain two new sections – Prop. Reg. §1.274-11 and Prop. Reg. §1.274-12.  

Prop. Reg. §1.274-11 reinforces the language contained in Notice 2018-76 regarding the deductibility of “certain business meals” incurred as part of an otherwise nondeductible entertainment activity. Prop. Reg. §1.274-12 addresses food or beverage expenses under IRC Section 274(k) (business meals) and IRC §274(n) (meals deductibility). The proposed regulations also contain a number of examples illustrating these changes.  While the proposed regulations provide useful clarification and confirmation in certain areas, many questions linger. This edition of Tax Advisor Weekly highlights specific guidance provided within the proposed regulations and recommends certain steps taxpayers can take to maximize their IRC §274 deductions for tax years 2019 and beyond.

“Entertainment” and the Food & Beverage Carveout 

Prior to TCJA, taxpayers were allowed a 50 percent deduction for entertainment expenses (IRC §274(n)(1)) “directly related” to the taxpayer’s trade or business or those that involved a “substantial and bona fide business discussion” (IRC §274(a)(1)(A)). However, TCJA eliminated the “directly related” and ”business discussion” exceptions while removing the reference to entertainment expenses in IRC §274(n)(1).  

While the overarching IRC §274(a)(1) definition of “entertainment” still applies, Prop. Reg. §1.274-11 further defines the terms “entertainment” and “food and beverage.” The proposed regulations specifically acknowledge that “the term entertainment does not include food or beverages unless the food or beverages are provided during, or at, an entertainment activity.” Further, the proposed regulations note that an “objective test” should be applied when assessing whether or not an activity generally constitutes “entertainment.” Finally, the four examples within Prop. Reg. §1.274-11 are similar to those contained within Notice 2018-76. The examples identify scenarios where food and beverage expenses remain partially deductible even though they are incurred as part of a broader nondeductible client entertainment. Taxpayers can deduct 50 percent of such food and beverage expenses as long as these costs are separately stated on the invoice AND/OR they are purchased separately from the entertainment itself.  

Definitions of Key M&E Terms

Prop. Reg. §1.274-12 addresses the limitations on deductions for certain types of food and beverage. Generally, food and beverage expenses remain 50 percent deductible so long as the following criteria are met: the expense is not “lavish or extravagant” under the circumstances, the taxpayer is present, and the food and beverage is provided to a business associate. These requirements are consistent with those outlined in Notice 2018-76 regarding business meal deductibility, as part of a broader entertainment event. However, the proposed regulations include two new examples where meals remain 50 percent deductible – 1. a taxpayer’s business lunch with a client and 2. a taxpayer’s performance review lunch with an employee. 

The proposed regulations define certain terms commonplace when determining M&E deductibility, including the following:

• Food or beverage – All food and beverage items, regardless of characterization (meals, snacks, etc.) and regardless of whether or not it is considered de minimis fringe under IRC §132(e).
• Business associate – Someone with whom the taxpayer could reasonably expect to do business with, including a customer, client, supplier, or employee, whether established or a prospect.
• Primarily consumed – Greater than 50 percent  of actual or reasonably estimated consumption
• General public – Customers, clients and visitors. The general public does not include employees, partners, independent contractors or those individuals on an exclusive list of guests.

Deductibility Exceptions and New Examples Within the Proposed Regs

After establishing qualifications of general meals deductibility and key definitions, the proposed regulations expand upon the exceptions to the 50 percent limitation. Most notably, the proposed regulations include examples demonstrating their application to “real world” scenarios.  

The exceptions and accompanying relevant examples are  as follows: 

• Expenses treated as compensation – Food and beverage expenses treated as compensation paid to a taxpayer or as wages to the employee are fully deductible to the taxpayer.  
• Expenses included as income to non-employees – Food and beverage costs included as compensation for services rendered to a non-employee of the taxpayer are fully deductible to the taxpayer.
• Reimbursed food or beverage expenses – The 50 percent food and beverage limitation applies either to the person who makes the expenditure or to the person who actually bears the expense, but not to both. In the event of an employee reimbursement arrangement, the 50 percent limitation shall apply to the taxpayer if the reimbursement is NOT treated as compensation paid to the employee or as wages to the employee. In the event of a non-employee reimbursement arrangement, the 50 percent limitation applies to the party expressly identified within the agreement between the parties or, in the absence of such an identification, to the client or customer if the contractor accounts to the client within the meaning of IRC §274(d) substantiation requirements.
• Food or beverage for employee recreational expenses – Food or beverage costs paid or incurred by a taxpayer for a recreational, social, or similar activity, primarily for the benefit of the taxpayer’s employees (other than highly compensated employees) are fully deductible to the taxpayer.  Any expenses that discriminate in favor of officers, shareholders, or other owners shall be subject to the 50 percent limitation. Following are examples to help explain:
  • Holiday Party  – A taxpayer invites employees to a holiday party at a hotel with a buffet and open bar.  The cost of the party, including the food and beverage expense, is 100 percent deductible as a social expense primarily for the benefit of non-highly compensated employees.
  • Party for Highly Compensated Individuals  – Assume the same facts as above, but the taxpayer only invites highly compensated individuals. The invoice provided by the hotel separately states food and beverage costs from the cost of the ballroom rental. The “primarily for the benefit” exception does not apply because the taxpayer only invited highly compensated individuals. However, the food and beverage portion of the invoice remains 50 percent deductible and should not be treated as entertainment under Prop. Reg. §1.274-11(b)(1)(ii).
  • Break Room Snacks – Free snacks, drinks, etc. available to all employees in a break room are only 50 percent deductible because the break room is not of a “recreational, social or similar activity.”
  • Meals for Shift Workers – Employees of a taxpayer in certain medical positions must be available at any time during their shift. The taxpayer provides meals around the clock and free of charge to these employees. The meals are excludable from employees’ income as provided for the convenience of the employer under IRC §119. Because these meals are provided for the employer’s convenience and not “primarily for the benefit of the employees,” they are 50 percent deductible.
  • Special Meals  – A taxpayer, an employee and a client attend a business dinner, but the taxpayer orders a special dessert for the employee because it is the employee’s birthday. Because the meal is a business meal (and therefore not “primarily for the benefit of the employee”), the meal is 50 percent deductible.
• Items available to the public – Food and beverage expenses made available to the general public are excluded from the 50 percent deductibility limitation as long as the food and beverages are provided to and primarily consumed by the public. Following are examples to help explain:
  • “Primarily Consumed” Refreshments – A real estate agent who provides refreshments at an open house can only deduct 100 percent of the cost of the refreshments if over 50 percent of the food and beverages is “primarily consumed” by potential buyers and other real estate agents (and not employees of the real estate agency). If not “primarily consumed” by the general public, only the specific costs attributable to the food and beverage provided to the general public can be deducted at 100 percent, with the remainder deducted at 50 percent.
  • “Primarily Consumed” Meals – A summer camp operator with 20 counselors and 100 campers provides the same breakfast and lunch to both counselors and campers alike. The two meals are included as part of the cost of the camp.  Since attendees consume more than 50 percent of the food and beverage, the cost of the two meals is 100 percent deductible to the camp operator.
• Goods or services sold to customers – Expenses paid or incurred for food or beverages to the extent the food or beverages are sold for their full value are not subject to the 50 percent limitation.  Restaurants or catering business may deduct 100 percent of the cost of food and beverage items for meals consumed by its employees at the worksite in conjunction with the preparation of meals for the taxpayer’s customers. An example includes:
  • Restaurant Industry Deductibility  – A taxpayer operates a restaurant and provides food and beverage to its foodservice employees before, during and after shifts for no consideration. These expenses are fully deductible to the taxpayer because the restaurant is in the business of selling food and beverage to its customers.

Alvarez and Marsal Taxand Says:

While perhaps not the ideal timing for release, the new proposed regulations do provide useful guidance with respect to the M&E changes of TCJA and Notice 2018-76.  Business meal deductibility as a subset of an otherwise disallowable entertainment event requires taxpayers to review invoices related to significant entertainment-related expenditures (sporting events, concerts, theater, etc.) for cost itemization detail.  If this information is not available, vendor requests should be made to properly substantiate the deductible portion of food and beverage incurred at such an event.  Substantiation is critical, as Treasury reaffirms its position that allocations cannot be made to “carve out” a reasonable portion of food and beverage expense as part of a broader nondeductible entertainment outing, if this information is otherwise unavailable.

Additionally, the proposed regulations reinforce the importance of proper substantiation when taxpayers submit expenses to clients under reimbursement arrangements.  In order to retain full deductibility, it is critical that a taxpayer “accounts to the client or customer” its incurred engagement expenses with: sufficient records (receipts, invoices, etc.) corroborating the amount of the expense, the time and place of the travel, the business purpose of the expense, and the business relationship to the taxpayer. Absent these considerations, taxpayers will likely only be able to deduct 50 percent of these costs.

The examples within the proposed regulations provide the potentially greatest insight into the application of the new M&E rules associated with the changes made as part of TCJA. For example, while a birthday celebration and a business meal are not mutually exclusive events, the “business” nature of the meal is the key-determining factor with respect to the deductibility of the expense. Further, as discussed in the Preamble, incidental occurrences of socialization (such as in the break room when grabbing snacks or when grabbing a sandwich during a working lunch) do not give rise to a “recreational, social or similar activity” that could be fully deductible under one of the exceptions in IRC §274(e)(4). Finally, the classification of a “performance review” lunch as 50 percent deductible reinforces the new definition of “business associates” as including employees and suggests that, similar to the “birthday” example, the underlying reason for the outing should be the ultimate factor when determining expense deductibility.   

The IRS has requested comments to the proposed regulations by the second week of April. Given the proposed nature of these regulations and the likely wave of forthcoming comments, we fully expect to see another round of comments or regulations addressing this feedback. Until then, please feel free to contact A&M Taxand with questions related to meals and entertainment deductibility.