2015-Issue 13—As companies continue to grapple with how to grow revenues, reduce costs and remain competitive in today’s global economy, corporate tax departments frequently find themselves under increased pressure to manage their effective tax rate. Many companies have found that the easiest path to managing the effective rate is to focus on the basic blocking and tackling efforts that book-tax differences can create. The meals and entertainment (M&E) deduction is an example of a permanent tax difference that companies have identified that can increase cash flow, reduce the effective rate and implement better controls. This edition of Tax Advisor Weekly focuses on the key technical requirements, planning opportunities, process controls and methodology changes available to taxpayers to increase the amount of deductible meals and entertainment expenditures.
The Basics on M&E
Internal Revenue Code Section 274(n)(1) limits the tax deductible amount of any food, beverage or entertainment outlay to 50 percent of the amount Section 162 otherwise allows as an ordinary and necessary business expense. This 50 percent deduction disallowance can create a significant permanent increase in taxable income for many taxpayers. The M&E expense limitation was originally enacted to control perceived abuses of deductions for these types of expenses, but Congress recognized that many M&E expenditures are beneficial to businesses and outlined statutory exceptions that allow for 100 percent deductibility of certain M&E expenditures. The determination of which costs meet these requirements is highly factual and can be labor intensive to identify.
Although ordinary and necessary business expenses are generally deductible, costs incurred for personal reasons are not. Under IRC Section 274(a), the M&E expenses a company incurs on behalf of clients, customers or employees must be:
- Directly related to the active conduct of the taxpayer’s trade or business;
- Ordinary and necessary (that is, not lavish or extravagant); and
- Properly substantiated.
To deduct any expense for business entertainment, the taxpayer must first demonstrate that such expense is “ordinary and necessary” and also prove that the expense was “related to the active conduct of the taxpayer's trade or business.” Section 162(a) allows a current deduction for those ordinary and necessary expenses incurred by a taxpayer in carrying on a trade or business.
Assuming a taxpayer meets the threshold tests of demonstrating that the M&E expense represents an ordinary and necessary business expense and then shows that the expense satisfies the “directly related” test or the “associated with” test, it must still satisfy the substantiation requirements of Section 274(d) and Reg. Section 1.274-5T. In general, either “adequate records” or “sufficient evidence” are required to substantiate the expense. The substantiation requirements are strictly construed, and the taxpayer’s failure to satisfy this burden will cause the entire expense to be non-deductible.
Any M&E expenditures that meet one of the statutory exceptions found in Section 274(n)(2) remain 100 percent deductible and exempt from the 50 percent exclusion of Section 274(n)(1). The exceptions of Section 274(n)(2)(A) and (B) are as follows:
- M&E expenses treated as compensation;
- Reimbursed expenses;
- Recreational expenses for employees (“primarily social” exception);
- Items available to the public;
- Entertainment sold to customers;
- Expenses includible in income of nonemployees; and
- Food or beverage expenses excluded from gross income of recipient as a de minimis fringe benefit under Section 132(e).
The exceptions that tend to hold the most opportunity for incremental deductions are the primarily social and de minimis fringe provisions. Although these provisions may seem fairly straightforward on the surface, a detailed analysis of these exceptions shows that there are a number of key factual points that must be analyzed in order to meet the exceptions. For example, the IRS defines de minimis fringe benefits as "any property or service the value of which is so small as to make accounting for it unreasonable or administratively impractical." The IRS specifically states that the frequency that benefits are offered must be taken into consideration. Therefore, in analyzing potential expenditures, the size of the group, the location of the meal, and the frequency of the meal type must be weighed. Similarly, the recreational and social exception is available for expenses “primarily” for the benefit of employees. Therefore, the purpose of the expense (i.e., is it for a qualifying social purpose) and the attendees (i.e., is it primarily qualifying employees) may impact the final determination. This is typically a very fact-based effort where the results will vary based on the information available to support the expense.
Although it is not possible to provide a complete list of possible overlooked exceptions, our experience indicates that the following examples highlight the most likely opportunities for taxpayers to claim a 100 percent deduction:
- Nominal food and beverage: Examples may include occasional group meals such as pizzas for an office gathering, buffet meals at training sessions, break-room drinks and snacks, occasional overtime group meals or continental breakfast for a morning meeting. These meals, entertainment and other employer-provided benefits tend to be relatively minor and administratively difficult to track.
- Social or recreational expenses: Examples in this category of exceptions include expenses for recreational or social activities such as holiday parties, summer picnics or outings, mentoring lunches or department lunches. The important thing to note is that such events cannot discriminate in favor of “highly compensated employees.”
- Meals provided for the convenience of the employer: Examples may include meals incurred for occasional in-office working breakfasts, lunches and dinners for the convenience of the employer.
- Reimbursed expenses: To the extent you incur an expense on behalf of a client or customer and pass that expense on with an adequate accounting, such expenses will generally be fully deductible, and the other party will be subject to the limitation.
- Misclassified expenses: It is common to find items miscoded by employees. This might include a car rental bill that is charged to a meals account.
Developing a Methodology to Manage M&E Expenditures
To manage the opportunity on a going-forward basis, it is frequently necessary to add new accounts to the general ledger or time and expense reporting system that will allow 100 percent deductible meal and entertainment expenses to be separately tracked. The addition of new accounts is often of limited value if employees are not informed of the importance of accurate reporting and educated on the types of expenses that will fall within the 100 percent deductible category. The information included in the time reporting system or on the documentation must support the exception. Documentation requirements include amount, time, place and business purpose of the expense, as well as the attendees related to the meals and entertainment expense.
The IRS reduced the burden of the fact-based exercise with the issuance of Revenue Procedure 2004-29, which describes the statistical sampling methods that may be applied to determine the amount of M&E expenses available for the 100 percent deductible category. Because the benefit of an M&E review involves looking at numerous transactions, applying some type of approved sampling method can significantly reduce your effort. The guidance also provides that up to three tax years can be covered in one statistical sample.
Alvarez & Marsal Taxand Says:
By examining M&E expenses for exceptions to the general 50 percent tax deduction limitation, most companies will realize an immediate benefit. Because the M&E disallowance is a permanent disallowance, the benefit derived from an M&E review can have an immediate benefit on earnings per share and cash payments. However, many of the exceptions from the 50 percent expense limitation are highly factual, and procedures must be applied to identify current opportunities and manage the costs in the future. It is essential that there is a system in place that can adequately track descriptions of expenses. Key factors such as the purpose of the meal, the meal attendees and the location of the meal must be supported by the documentation. Understanding and correctly applying the technical complexities in conjunction with the expense details will have a significant impact on the overall benefit.
Senior Director, Houston
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Kathleen King, Managing Director, contributed to this issue.
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