- This article attempts to help provide clarification for taxpayers in avoiding conflicts with the IRS with respect to business meals.
- On January 1,2018, The Tax Cuts and Jobs Act (TCJA) invalidated the general deduction of business entertainment expenses. Nonetheless, the TCJA left in place the deduction of food and beverage expenses as a business expense (typically, at 50% of the expense amount). However, due to a long-established practice of regarding business meals and entertainment as coinciding expenses, businesses sought guidance on the disentanglement of the two.
- IRS clarification was provided in October 2020 requiring tax advisors and taxpayers to prudently apply the final regulations for documenting business food and beverage expenses to ensure a deduction qualifies as a claimable expense.
- Sufficiently documenting the expenses is now key to avoiding any associated tax return issues. The details about documented expenses vary for those incurred in the taxpayer’s “tax home”compared with those paid or incurred while travelling for business “away from home.”
For decades, the business meal tax deduction has been a source of controversy and slow curtailment. Recently, uncertainty has grown concerning the availability and requirements for the business meal deduction specifically due to its sudden separation from its conventional tax deduction counterpart — the business entertainment expense deduction. Yet, with the enactment of final regulations in 2020, the IRS has provided direction on deducting the costs of business meals separately from entertainment. With the recent guidance, the deduction has even been temporarily restored to its former significance, granting the total expense of such meals to be deducted under certain circumstances.
Let’s recap the history of the deduction and scrutinize the 2020 final regulations with their inferred separate treatment of business meals consumed while traveling away from the taxpayer’s home. Additionally, we’ll review guidance which taxpayers may use to help document and substantiate their claims to the business meal deduction.
A history summary of the business meal tax deduction
Business meals and other expense deductions are among the most querulous issues in tax law. Business travel expenses deducted under Sec. 274(d) were 20% of all the business tax issues litigated in cases brought in federal courts during a 2019-2020 one-year period. Confusion over how and when business tax deductions may be claimed is a significant source of many disputes with the IRS. The business meal deduction was cut to 80% of the cost in 1986, then to 50% of the cost, effective Jan. 1, 1994. (For 2021 and 2022, the deduction is 100% for meals purchased from a restaurant.) On January 1st, 2018, Section 13304 of the U.S. Tax Code known as the Tax Cuts and Jobs Act (TCJA) forcefully excluded from Sec. 274 the deduction for most entertainment expenses, without regard to how the entertainment may relate to a business relationship or activity. Because the TCJA did this by simply striking references to the most common allowable entertainment expenses from Sec. 274, the conventional norm of treating meals and entertainment as broadly interchangeable caused some confusion. Rumors soon thrived that the IRS would treat “business meals” as a form of entertainment and they would also become nondeductible.
The confusion highlighted two main issues. Foremost, the long-standing legal overlay between a business meal and business entertainment had, in fact, reflected the practical overlay between business meals and business entertainment. In effect, blurred lines were created. The business meal has never essentially been a focus on the acquisition of nutrition; it has been about a shared experience. Second, Congress failed to define “entertainment” as a notion separate from “meals” in the business context when it removed references to entertainment from Sec. 274. Because of the long practice of treating business meals and entertainment as merely different perspectives on the same transactions, removal of the entertainment deduction raised questions on the continued validity of the other.
In October, 2018, the IRS announced Notice 2018-76, which provided interim rules until final regulations could be issued. In February 2020, the IRS released proposed regulations (REG-100814-19), and in October 2020 the IRS provided final regulations that retired Notice 2018-76.
Entertainment definition in final regulations: Regs. Sec. 1.274-11(b)(1) of the final regulations, as had Notice 2018-76, incorporated the definition of entertainment found in Regs. Sec. 1.274-2(b)(1). Regs. Sec. 1.274-11(b)(1)(i) defines “entertainment” as “any activity which is of a type generally considered to constitute entertainment, amusement, or recreation,” listing as examples “entertaining at bars, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips.”
Under Regs. Sec. 1.274-11(b)(1)(ii), a taxpayer applies an “objective test” to evaluate whether an activity is “of a type generally considered to constitute entertainment.” If, under the objective test, the activity is generally considered to be entertainment, it is entertainment for purposes of Sec. 274(a) and the regulations, regardless of whether it could be described as something other than entertainment and even if the expense relates to the taxpayer alone. The objective test precludes arguments that “entertainment” means only entertainment of others or that entertainment expenses should be treated as advertising or public relations expenses.
However, Regs. Sec. 1.274-11(b)(1)(ii) further provides that a taxpayer’s trade or business is taken into consideration. For example, a theatrical performance is not entertainment for a professional theater critic attending the performance in a professional capacity, and a fashion show by a dress manufacturer to introduce its products to a group of store buyers generally would not constitute entertainment.
Meal expense deduction rules in final regulations: Under Regs. Sec. 1.274-12(a)(1), a taxpayer may deduct 50% of an otherwise allowable meal expense if:
- 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; and
- The food and beverages are provided to a taxpayer or a business associate.
In addition, 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. This rule may not be circumvented through inflating the amount charged for food and beverages.
In the third requirement in the final version of Regs. Sec. 1.274-12(a)(1), the IRS made a key change from the proposed regulations to the description of persons who are considered suitable recipients of tax-deductible business meals, adding “taxpayer” to that description. This change allows self-employed taxpayers to access the deduction.
Business associate definition: For the definition of “business associate,” the IRS inserted in Regs. Sec. 1.274-12(b)(3), nearly intact, the definition from Regs. Sec. 1.274-2(b)(2)(iii), which addressed the now-repealed “active conduct of business” requirement of Sec. 274(a)
before its references to deductibility of entertainment expenses were eliminated by the passage of Section 13304(a) of the TCJA. Thus, as Regs. Sec. 1.274-2(b)(2)(iii) does, Regs. Sec. 1.274-12(b)(3) includes a taxpayer’s employee within the scope of the business-associate requirement, thereby enabling tax-deductible business meals to include a mix of employees and customers. The relevant regulation section now reads:
Business associate. Business associate means 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.
Absent from the types of relationships that are at least nominally included within the scope of a “business associate” for purposes of the deduction are persons with whom a taxpayer is simply cultivating goodwill. For instance, a business person working to grow or maintain his or her name recognition and reputation within a community might routinely host meals with local business leaders with whom he or she does not expect ever to directly do business but who might eventually be in a position to refer someone else to him or her. It is not clear that the word “prospective” in the regulation saves such indirect relationships from exclusion from the defined category.
Travel and non travel meal expenses
Left unchanged by the TCJA were the rules for travel meal expenses. Nonetheless, the regulations consolidate the non travel meal expense deduction rules with those for travel, underscoring that a deduction of the cost of meals purchased while traveling is subject to the heightened substantiation requirements of Sec. 274(d).
Definition of a travel meal: Sec. 274(d) disallows insufficiently documented deductions for meals while away from home, but neither the Code nor the regulations explain what the phrase “away from home” means for tax purposes. The Supreme Court took up the issue in Correll and opined that the IRS’s long-standing position, summarized initially as the overnight rule and later adopted as the “sleep or rest rule,” was legally valid. The sleep-or-rest rule disallows any deductions associated with business travel away from home unless the travel requires sleep or rest to meet the needs or exigencies of the taxpayer’s employment.
Thus, for purposes of deductions under Sec. 274(d), a taxpayer’s tax “home” is the taxpayer’s regular or principal (if more than one regular) place of business.
Deductibility of travel meals: The regulations concerning travel meals apply the above three tests for deductibility of non travel meals.They also apply the enhanced substantiation requirements of Sec. 274(d), which disallows any deduction for, among other things, meals as part of traveling expenses unless:
the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the time and place of the travel or the date and description of the gift, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of the person receiving the benefit. The Secretary may by regulations provide that some or all of the requirements of the preceding sentence shall not apply in the case of an expense which does not exceed an amount prescribed pursuant to such regulations.
In Temp. Regs. Sec. 1.274-5T(b)(2), the IRS provides that for purposes of Sec. 274(d), in the case of expenses for travel, the taxpayer is only required to substantiate the amount, time, place, and business purpose of the expense. However, with respect to time, the taxpayer must substantiate the date of departure and return for the travel, and that with respect to place, the taxpayer must substantiate the destination or locality of the travel, by city or town or similar designation. The regulations further provide that the four elements must be substantiated “by adequate records or by sufficient evidence” that corroborates the taxpayer’s own statement.
Temp. Regs. Sec. 1.274-5T(a) states that the substantiation requirements of Sec. 274(d) supersede the judicial doctrine in Cohan, 39 F.2d 540 (2d Cir. 1930), under which, if a taxpayer provides evidence that an expense occurred, but not its exact amount, a court may estimate the amount of the expense and not disallow the entire deduction. Thus, if the IRS disallows a deduction for travel meals, and the taxpayer cannot provide adequate records or evidence to substantiate all the elements in Temp. Regs. Sec. 1.274-5T(b)(2), a court must uphold the disallowance of the entire deduction.
Documentation needed for travel and non travel business meals deductions
Sec. 6001 places the burden on taxpayers to keep records that support their tax positions. The regulations further detail that a taxpayer “shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information.” Essentially, taxpayers must prepare and maintain written records that support everything that appears on their federal tax returns.
The responsibility for documenting claims associated with the tax return rests exclusively on the persons whose names appear at the top of those returns. The taxpayer must consider what records support a claimed deduction for a business meal that includes a taxpayer and a prospective customer of that taxpayer.
Non Travel business meals: First, the documentation must demonstrate compliance with the threshold requirements of Sec. 162(a) and Regs. Sec. 1.162-1 in three ways: The meal expense must be ordinary, necessary, and directly connected with, or pertaining to, the taxpayer’s trade or business.
Next, as mentioned above, Regs. Sec. 1.274-12(a)(1) requires that:
- 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; and
- The food or beverages are provided to the taxpayer or a business associate.
A long trail of Tax Court opinions describes the results of inadequate documentation of claimed business deductions — generally, their disallowance, principally because adequately supportive records of the business relationship of the expenses to the taxpayer were not provided, or the records substantiating the business purpose of the expense were not prepared contemporaneously with the expense.
Note that these issues do not go directly to deductibility but to the recordkeeping requirement of Sec. 6001. In brief, business meals must be substantiated in five respects:
- Amount of the expense;
- Date of the expense;
- Location of the expense;
- Business purpose of the meal; and
- Identification of who was present at the meal.
Travel meals: Deductibility of a travel meal gets different, higher scrutiny. Regs. Sec. 1.274-12(a)(4) provides special rules for travel meals. This subsection invokes by reference paragraphs (a)(1) and (a)(2) of the regulation, so the three requirements of Regs. Sec. 1.274-12(a)(1) must be substantiated, just as they must be for non travel meals. In addition, Regs. Sec. 1.274-12(a)(4) also refers to the statutory substantiation requirements of Sec. 274(d). Accordingly, a taxpayer who qualifies as away from his or her tax home and wants to deduct the cost of a meal must, in addition to documenting the requirements in Sec. 162(a) and its associated regulations and Regs. Secs. 1.274-12(a)(1) and (2), document that the substantiation requirements of Sec. 274(d) were met. The business purpose of a meal consumed by just the taxpayer is impliedly demonstrated by meeting the requirements of the “sleep-or-rest” rule of Correll described above.
Publication 463: Likely adding to, or at least not resolving, the uncertainty surrounding the substantiation issues for business meals is the IRS guidance in Publication 463, which defines, with regard to business meals, that a restaurant receipt is enough to prove an expense for a business meal if it has all of the following information:
- The name and location of the restaurant;
- The number of people served; and
- The date and amount of the expense.
According to the final regulations, a restaurant receipt with this information on its own would not be adequate substantiation for either a non travel or travel business meal, as it would not address the requirements of either subparagraph (ii) or (iii) of Regs. Sec. 1.274-12(a)(1) and only addresses the requirement of subparagraph (i) by implication (presumably, some evaluation that the meal was not lavish is made by division of the total cost by the number of people served). For travel meals, a receipt with this information also would be inadequate to substantiate either the time, place, or business purpose elements in Sec. 274(d) and Temp. Regs. Sec. 1.274-5T(b)(2). Sec. 274(d), as discussed above, provides that all travel expenses, including travel meal expenses, are not allowed unless that taxpayer “substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement” each of the required elements for the expense.
Form of documentation: The documentation requirement for substantiating both travel and non travel meals can be satisfied by simply writing on the back of the restaurant receipt the names of the persons present at the meal and a summary of the business discussion. If the meal is a travel meal and just the taxpayer consumes it, a note about the business purpose of the travel is adequate to satisfy the sleep-or-rest rule. In his own practice, the author advises clients that, in the event of an IRS examination of a return, the note should be sufficiently detailed to credibly prompt their memories and support reasonably meticulous recitations of the business content of meetings that, by the time of an IRS examination, may have occurred several years before.
Establishing sound recordkeeping habits
Recordkeeping for business meals requires a plan joined with steady execution. Insufficient records result in the disallowance of deductions and the repercussion of underreporting of income.
Millan and Company is here to advise clients of the travel and non travel rules regarding business meal deductions.
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