In the midst of the COVID-19 pandemic, most everyone is staying home; entertainment and meals outside the home bubble are not on the agenda. But, someday, life will return to normal and we will eat out again! The economy will pick up and clients, prospective customers and associates will look to meet and enjoy a meal or entertainment in the ordinary course of doing business. So, let’s be optimistic and see what and how much can be deducted on the US income tax return for such expenses. For US persons abroad who are running their own businesses, these deductions can be very important, but sadly are often overlooked or not properly substantiated.
Lean and Mean – Tax Cuts and Jobs Act
The 2017 Tax Cuts and Jobs Act (TCJA) did away with many deductions beginning in 2018 including entertainment expenses associated with a taxpayer’s trade or business, while business meal expenses remained partially deductible. Here’s the lowdown on the current rules and bringing you up to date on the latest Internal Revenue Service (IRS) pronouncements in this area.
Prior to TCJA, Internal Revenue Code Section 274(a)(1)(A) generally prohibited a deduction with respect to an activity of a type considered to constitute entertainment, amusement, or recreation (“entertainment expenses”). Exceptions applied if the taxpayer could show the expense met one of two possible exceptions (which if met, allowed the taxpayer to deduct 50% of the expense). The taxpayer had to establish that: (1) the item was directly related to the active conduct of the taxpayer’s trade or business (the “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), that the item was associated with the active conduct of the taxpayer’s trade or business (the “business discussion” exception). Significantly TCJA completely eliminated the deduction for entertainment, amusement and recreation and associated expenses.
Prior to TCJA, taxpayers could deduct 50 percent of meal expenses related to the taxpayer’s business.
With the enactment of TCJA while entertainment expenses are no longer deductible, otherwise allowable meal expenses remain deductible, subject to the 50 percent limitation in Code Section 274(n)(1).
Entertainment? No Deduction
What constitutes “entertainment”? An objective test is used to determine whether an activity is of a type generally considered to constitute entertainment. If an activity is generally considered to be entertainment, it will constitute entertainment for purposes of Code Section 274 regardless of whether the expenditure for the activity can also be described as something else (e.g., as an expenditure made for public relations or advertising purposes), and even though the expenditure relates to the taxpayer alone. In applying this test, however, the IRS will look to the taxpayer’s trade or business. For example, attending a theatrical performance would generally be considered entertainment, but it would not be considered entertainment for a professional theater critic attending in a professional capacity. Similarly, if a manufacturer of dresses conducts a fashion show to introduce its products to a group of store buyers, the show generally would not be considered to constitute entertainment. In contrast, if an appliance distributor conducts a fashion show for its retailers, the fashion show generally would be considered to constitute entertainment.
Certain exceptions are provided in Code Section 274(e)(1)-(9) to the “no deduction” rule for entertainment expenses. TCJA did not change these exceptions. For example, deductions are permitted when the entertainment expenses are treated as “compensation” to the recipient. Example: when an employer provides an employee with seasonal opera tickets for himself and his family, and treats the expense as “bonus” compensation to the employee.
Food and Beverages
Taxpayers generally may continue to deduct 50 percent of the food and beverage expenses associated with operating their trade or business. The tricky part comes in determining when business-related meal expenses are to be treated as nondeductible entertainment expenses or when they are 50 percent deductible expenses. In the real world, one often enjoys a meal and beverage while being entertained.
Guidance
The IRS provided some helpful guidance in late 2018 when it issued Notice 2018-76 describing when meal expenses incurred before, after or during entertainment-related activities may still qualify for deduction. On February 26, 2020 the IRS published proposed regulations on this topic. These regulations may be relied upon by taxpayers until the publication of final regulations. Taxpayers may also rely on Notice 2018-76 until the proposed regulations are finalized. For the most part, the proposed regulations track the earlier IRS guidance in the Notice, but they further clarify the circumstances under which meals remain deductible.
A concise summary follows. Taxpayers may deduct 50 percent of an otherwise allowable business meal expense if: 1. The expense is an ordinary and necessary expense in carrying on a 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 “business associate” as defined in Treasury Regulation Section 1.274-2(b)(2)(iii). Thus, in contrast to the Notice, the proposed regulations provide that the food or beverages must be provided to a “person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business such as the taxpayer’s customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective.”; and 5. In the case of food and beverages provided during or at 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. The entertainment disallowance rule may not be circumvented through inflating the amount charged for food and beverages.
Comments to the IRS on the proposed regulations are due by April 13, 2020, and a public hearing is scheduled for April 7, 2020.
Substantiate the Expenses!
In addition to IRS guidance on these issues, taxpayers are reminded that such expenses remain subject to the substantiation requirements of Internal Revenue Code Section 274. Many taxpayers do not keep good records. This will mean valuable deductions can be lost. Food and beverage expenses are subject to the substantiation requirements under Code Section 162 and the requirement to maintain books and records under Code Section 6001.
Taxpayer Advocate Service (TAS) has written an excellent summary covering the issues involved with taking business expense deductions,including some detail on the substantiation rules for Code Section 162 purposes.
Posted March 26, 2020
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