Regs aim to clarify meal, entertainment deduction

The IRS has issued proposed regulations (REG-100814-19) clarifying and expanding on the rules for deducting certain business meal and entertainment expenses. The long-awaited regulations build on the guidance issued under Notice 2018-76, expanding ability for taxpayers to deduct a portion of business meals with employees and narrowing eligibility for the full deduction for meal expenses that may have previously been claimed in certain situations as related to employee recreational and social activities.

The proposed regulations implement the legislative changes to meals and entertainment deductions enacted as part of the Tax Cuts and Jobs Act (TCJA), and provide additional guidance on existing exceptions to the 50% limit on meal deductions. Much of the new guidance offers taxpayer-favorable clarifications that could present opportunities for additional permanent deductions, including for certain separately stated food and beverage costs during an entertainment activity and business meals with an employee instead of a customer or client.

However, the proposed regulations also contain some clarifications that may be unfavorable, such as applying the 50% limit to food or beverages provided to employees in company break rooms. Taxpayers should carefully assess the impact of the changes and any opportunities. The proposed rules are not effective until final, but may be relied upon for expenses paid or incurred after Dec. 31, 2017. Taxpayers may also continue to rely on Notice 2018-76 until the final regulations are issued.

Background

The TCJA eliminated the ability for businesses to deduct entertainment expenses (unless certain narrow exceptions apply) for amounts paid or incurred after Dec. 31, 2017. TCJA generally left intact the deduction for meal expenses, which are generally subject to a 50% limit. Certain narrow exceptions to the limit still allow for a 100% deduction for meals in some circumstances, but TCJA repealed the exception to the 50% limit for food or beverages excludable from employee income as a de minimis fringe benefit under Section 132(e). Beginning in 2026, the deduction for these de minimis fringe benefits is scheduled to be eliminated completely when associated with an employer facility.

The repeal of the deduction for entertainment expenses along with the retention of the deduction for meals created uncertainty because the definition of entertainment in the existing regulations is broad enough to include meal expenses. Yet the legislative history clearly provides that taxpayers should still generally be able to deduct 50% of meal expenses associated with operating their business.

In response, the IRS issued Notice 2018-76 in October 2018 to provide that taxpayers may deduct 50% of an otherwise allowable business meal expense if:

• The expense is an ordinary and necessary expense under Section 162(a) paid or incurred during the taxable year in carrying on any trade or business.
• The expense is not lavish or extravagant under the circumstances.
• The taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages.
• The food and beverages are provided to a current or potential business customer, client, consultant or similar business contact.
• 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.

Entertainment, amusement, or recreation expenditures disallowed

The proposed regulations restate the statutory rules under Section 274, which provide that no deduction is allowed for expenses with respect to an activity generally considered to be entertainment, or a facility used in connection with an entertainment activity.

The proposed regulations substantially incorporate the existing definition of entertainment in the regulations, but clarify that, for purposes of Section 274, the term “entertainment” does not include food or beverages, except for those provided as part of an entertainment activity. In the case of food or beverages provided during or at an entertainment activity, the food or beverages are not considered entertainment 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 activity on separate bills. Unless these criteria are met, no allocation can be made and the entire amount is nondeductible. The amount charged for food or beverages must reflect the venue’s usual selling cost for those items if they were to be purchased separately from the entertainment or must approximate the reasonable value of those items.

Grant Thornton Insight: The proposed regulations generally rely on the old objective test. The request for comments on other issues related to entertainment expenses being non-deductible indicates that the IRS is contemplating further guidance around the treatment of entertainment expenses. Until then, taxpayers may wish to consider the way they purchase and document purchases of food or beverages during or at an entertainment activity. By either separately purchasing food or beverages from entertainment, or requesting bills that separately state the cost of food or beverages from the cost of the entertainment activity, taxpayers may treat the food or beverage expenses as 50% deductible instead of nondeductible, if otherwise allowable.

Deduction for business meals

The proposed regulations generally allow a 50% deduction for food and beverages if the following three requirements are met:

• The expense is not lavish or extravagant under the circumstances
• The taxpayer, or an employee of the taxpayer, is present at the furnishing of such food or beverages
• The food or beverages are provided to a business associate

The proposed regulations define food or beverage expenses to include “any delivery fees, tips, and sales tax.” However, food or beverage expenses do not include any other expenses related to providing the meal (e.g. servers, plates, etc.) if meals are provided by an employer at an eating facility on the employer’s business premises.

Grant Thornton Insight: The IRS received several questions regarding the types of costs to be included in “food or beverage expenses,” and this definition is provided as a response to the requests. However, Section 274(o), which is effective for amounts paid or incurred after Dec. 31, 2025, will include these types of costs, as well as food or beverage expenses themselves, and make any employer-operated eating facility non-deductible. We expect additional guidance addressing this issue in the future.
The proposed regulations introduce and define the term “business associate” as 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.

Grant Thornton Insight: The definition of business associate provides additional clarity on whether a taxpayer may deduct 50% of an otherwise allowable business meal expense. Under Notice 2018-76, the food and beverages must be provided to a current or potential business customer, client, consultant or similar business contact. The proposed regulations provide welcome clarification that a business associate includes an employee. This expanded definition is illustrated by an example of allowing a 50% deduction for the food and beverage expenses incurred by the taxpayer where the taxpayer takes an employee out to lunch and discusses the employee’s annual performance review.
The proposed regulations also provide special rules for travel meals. Food or beverage expenses paid or incurred while traveling for business purposes are generally subject to the 50% deduction limitations outlined above, as well as the substantiation requirements provided in Section 274(d). Furthermore, the proposed regulations clarify that no deduction will be allowed for travel meal expenses of a spouse, dependent or others accompanying the taxpayer or an employee of the taxpayer while on business travel, unless 1) the person is an employee of the taxpayer, 2) it is for a bona fide business purpose of the taxpayer, and 3) the expense would otherwise be deductible by the spouse, dependent or other individual.

Exceptions to the food and beverage deduction limitation

The proposed regulations expand on several of the exceptions that are still available to the 50% deduction limitation for food and beverage expenses.

Expenses treated as compensation In general, if an employee is the recipient of food or beverages, the employer is not subject to the deduction limitation to the extent that the expense is treated:

• As compensation paid to the employee on the taxpayer’s income tax return as originally filed
• As wages to the employee for purposes of withholding under Chapter 24 of the Code, relating to collection of income tax at source on wages

However, to the extent that the employer includes in the employee’s gross income less than the amount required to be included in gross income under Treas. Reg. Sec. 1.61-21, or if the amount required to be included in gross income is zero, the exception to deduct 100% does not apply.

Reimbursed food or beverage expenses

For food and beverage expenses paid or incurred by one person performing services for another, the deduction limitations apply either to the person who makes the expenditure or to the person who actually bears the expense, but not to both, regardless of whether the two persons are in an employer-employee relationship or not.

The proposed regulations distinguish how the reimbursement arrangements should be treated between employees and independent contractors:

• For employees, the limit applies to the employee to the extent the employer treats the reimbursement as compensation and wages paid to the employees. If not, the limit applies to the payor.
• For independent contractors, the limit applies to the party that is specifically identified in an agreement. However, if the agreement is silent, then the limit applies either to the independent contractor to the extent that the independent contractor does not account to the client/customer, or to the client/customer if the independent contractor accounts to the client/customer within the meaning of Section 274(d).

Recreational expenses for employees

The 50% limit does not apply for food or beverage cost for a recreational, social, or similar activity, primarily for the benefit of taxpayer’s employees, provided that such food or beverages are not available under circumstances which discriminate in favor of officers, shareholders, other owners or highly compensated employees. Examples of expenses meeting this exception include holiday parties, annual picnics or summer outings.

Grant Thornton Insight: The proposed regulations, through an example, clarify that free food or beverages provided to all employees in a break room do not meet the 100% exception. According to the example, the mere provision or availability of food or beverages is not a recreational, social or similar activity, despite the fact that employees may incidentally socialize while they are in the break room. Taxpayers should take caution against deducting 100% of such food or beverages.

Items available to the public

The 50% limit does not apply to the extent that such food or beverages are made available to and primarily consumed by the general public. The proposed regulations define the term “general public” to include customers, clients and visitors, but not employees, partners or independent contractors of the taxpayer. An exclusive list of guests is not considered the general public. Furthermore, the term “primarily consumed” is defined as greater than 50% of actual or reasonably estimated consumption. If the food and beverages are not primarily consumed by the general public, only the costs associated with the food and beverages actually provided to the general public will meet the deduction limitation exception.

Goods or services sold to customers

The 50% limit does not apply to the extent food or beverages are sold to customers in a bona fide transaction in money or money’s worth. However, the proposed regulations provide that “money or money’s worth” does not include payment for providing services. The proposed regulations further provide that a “customer” includes anyone, including an employee of the taxpayer, so long as the transaction itself includes a sale of food or beverages in a bona fide transaction for an adequate and full consideration in money or money’s worth.

Grant Thornton Insight: There is an opportunity for restaurants and catering businesses to deduct 100% of their costs for food or beverage items purchased in connection with preparing meals to its paying customers, which are also consumed at a work site by employees who work in the employer’s restaurant or catering business. While the Joint Committee on Taxation’s Bluebook acknowledged this unique fact pattern, taxpayers may now rely on explicit guidance in the proposed regulations.

Applicability date

The proposed regulations are generally applicable to taxable years beginning on or after the date on which final regulations are filed with the Federal Register. Pending issuance of the final regulations, taxpayers may rely on the proposed regulations for meal or entertainment expenditures paid or incurred after Dec. 31, 2017. In addition, taxpayers may rely on the guidance in Notice 2018-76 until the proposed regulations are finalized.

Next steps

The proposed rules contain several taxpayer-favorable clarifications that may present potential opportunities for additional permanent deductions. The term “entertainment” no longer includes food or beverages unless provided at or during an entertainment activity and costs are not separately stated from entertainment costs. As such, taxpayers may wish to consider the way in which food or beverages during or at an entertainment activity are purchased or documented in order to treat the expenses as 50% deductible rather than nondeductible. Additionally, the proposed regulations expand the definition of the term “business associate” to include an employee, which may provide an opportunity for taxpayers to deduct 50% of certain meals that were previously limited to business customers or clients.

However, taxpayers should note that not all proposed changes are favorable. Taxpayers should consider that the proposed regulations clarify that complimentary food or beverages provided to employees in company break rooms are subject to the 50% disallowance. Taxpayers that have paid or incurred meal and entertainment expenses after Dec. 31, 2017, should carefully consider the proposed rules and evaluate the deductibility of such costs, along with data capture, documentation and substantiation.

Contacts: