Navigating around limits on meals and entertainment

Business meals are generally deductible business expenses if the taxpayer proves a business connection. Entertainment expenses (meaning those of a type generally considered to be entertainment, amusement, or recreation) are fully nondeductible even if there is a business connection for the expense unless it falls into one of the exceptions listed below. The 50% disallowance rule limits the business deduction for certain otherwise deductible meals.

General rules

Meal expense deductions are subject to several conditions and limitations, some of which are common to business deductions generally. The requirement of a business connection for entertainment expenditures is specified in the Code by reference to particular facts and circumstances.

Meals

Meal expenses incurred by a taxpayer are deductible only if the expenses satisfy the following strict requirements imposed by the Code:

Ordinary and necessary: Meal expenses must be ordinary and necessary (Sec. 162(a)). An ordinary expense is one that is common and accepted in the taxpayer’s business, trade, or profession. A necessary expense is one that is helpful and appropriate, although not necessarily indispensable, for the employer’s business, trade, or profession.

Business connection: There must be a clear connection between the meal and a business event (such as a discussion, meeting, transaction, or negotiation). That is, the taxpayer must prove a valid business purpose for the business event that occurs before, during, or after the meal (Sec. 274(a) and Notice 87-23).

Lavish or extravagant: The meal cost is deductible only to the extent it is not lavish or extravagant under the circumstances. Any portion deemed to be lavish or extravagant is not deductible (Sec. 274(k)).

Substantiation: A deduction is allowed only for meal expenses that are properly substantiated (Sec. 274(d)).

Taxpayer’s presence: The taxpayer or a representative must be present (Sec. 274(k)).

Entertainment

Entertainment includes food or beverages if they are provided during or at an entertainment activity and are not purchased separately from the entertainment activity, or the cost of the food and beverages is not stated separately from the cost of the entertainment on one or more bills, invoices, or receipts (Regs. Sec. 1.274-11(b)(1)(ii)).

Food and beverage expenses are excluded from otherwise disallowed entertainment under specific exceptions in Sec. 274(e). They may be deducted only if the expenses:

• Were related to food and beverages for employees furnished on the business premises of the taxpayer;
• Were treated as compensation to the employee who received the benefit;
• Were paid or incurred by the taxpayer in connection with the performance of services for another person and were reimbursed under an accountable plan;
• Were recreational, social, or similar activities (including use of facilities) primarily for the benefit of non-highly compensated employees;
• Were directly related to business meetings (not before or after the meeting);
• Were directly related and necessary to attendance at a business meeting or convention of a Sec. 501(c)(6) organization, such as business leagues and chambers of commerce;
• Are expenses for goods, services, and facilities made available by the taxpayer to the general public;
• Are expenses for entertainment sold to customers; or
• Are includible in the income of persons who are not employees as compensation for services rendered or as a prize or award.

See further details on these exceptions below.

Normally, any activity that is generally considered to be entertainment will be treated as subject to the limitation on deducting expenses under Sec. 274(a).

However, a taxpayer’s trade or business must be considered. For example, a theatrical performance, which would normally be considered an entertainment expense, would not be an entertainment expense for a professional theater critic attending the performance in a professional capacity (Regs. Secs. 1.274-11(b)(1)(iii), 1.274-12(a)(1), and 1.274-12(b)(3)).

Example 1. Business meal for a client: G takes M, her long-term advertising client, out to lunch. During lunch, they discuss M’s new advertising campaign. G may deduct the cost of the meal, subject to the 50% limitation.

Example 2. Business meal for an employee: G takes J, her employee, to lunch. While eating lunch, they discuss J’s annual performance review. G may deduct the cost of the meal, subject to the 50% limitation.

Example 3. Food and beverages incurred at entertainment event: H, an attorney specializing in estate planning, invites M, a CPA, and L, a potential client, to a football game. While at the game, H pays for all of M’s and L’s refreshments. The cost of the game tickets are nondeductible entertainment expenses. The cost of the refreshments purchased separately at the game are deductible business meal expenses, subject to the 50% limitation.

Variation A: H invites M and L to share his company suite for the game, where they have access to food and beverages. The cost of the food and beverages is included in the suite package and is not invoiced separately. The entire cost of the outing is considered a nondeductible entertainment expense.

Variation B: The cost of the food and beverages is stated separately in the invoice for the company suite and reflects the venue’s usual selling price for food and beverages if purchased separately. The cost of the suite is still a nondeductible entertainment expense, but the cost of the food and beverages is a deductible meal expense, subject to the 50% limitation.

Skybox rentals and associated meals

The full cost of renting a private enclosed unit in a stadium or arena, or skybox, is nondeductible (Sec. 274(g)). However, business meals provided in the skybox may be deductible (subject to the 50% disallowance rule unless they meet an exception) if a business discussion takes place and if the meals are billed or stated separately from the cost of the sky-box rental.

Coping with the disallowance rules for costs related to entertainment facilities

Generally, a self-employed taxpayer cannot deduct any expenditures for an entertainment facility even if there is a business connection (Sec. 274(a)(1)(B)). An entertainment facility is any property owned or rented and used for entertainment, amusement, or recreation (Regs. Sec. 1.274-2(e)(2)). Examples of entertainment facilities include yachts, hunting lodges, hotel suites, fishing camps, and swimming pools.

However, out-of-pocket expenses incurred while providing meals at an entertainment facility are treated like other meal expenses. These expenses may be deducted (subject to the 50% disallowance rule) if the taxpayer proves a business connection.

Example 4. Operation of and costs related to an entertainment facility: F paid $5,000 to lease hunting rights to entertain current and prospective business clients. He kept logs establishing 100% business use of the lease. He also incurred $1,000 for food, drink, equipment, and supplies used during hunting expeditions. Substantial business discussions occurred during these expeditions.

The $5,000 lease fee is a nondeductible entertainment facility cost. However, the $1,000 of other expenses is not affected by the entertainment facility rules; rather, their treatment would be determined by the general rules of Sec. 274 governing meal expenses (ie, related to the business and properly substantiated).

Planning around the 50% disallowance rule for meals

Only 50% of otherwise allowable meal expenses are deductible as business expenses (Sec. 274(n)(1)). This includes business meals while attending professional seminars and while traveling away from home. If a hotel or other lodging establishment includes meals in its room charge, a reasonable allocation must be made to determine the portion of the expenditure subject to the 50% disallowance (Notice 87-23).

Taxes and tips related to meals are included in the amount that is subject to the 50% limit, as are expenses for cover charges to clubs, room rental for a dinner or cocktail party, and amounts paid for parking at a restaurant. However, transportation costs incurred in getting to and from the meal are not subject to the 50% disallowance. When a self-employed taxpayer uses a per diem method for travel expenses, the federal meal and incidental expense (M&IE) rate is treated as an expense for food and beverages and is therefore subject to the 50% disallowance.

Example 5. Costs subject to 50% disallowance: F meets with a business associate at a local restaurant for dinner. The cab fare to the restaurant and back is $25. The meal costs $100, including $18 for tips and tax. The cab fare is fully deductible. Only 50% of the $100 meal cost can be deducted.

Example 6. Disallowance of meal expenses incurred while traveling: F travels extensively. During the year, F incurred $3,000 in meal expenses while traveling on business. He can deduct $1,500 (50% of $3,000) for meals on his Schedule C, Profit or Loss From Business (Sole Proprietorship).

However, certain meal expenses are exempt from the 50% disallowance rules (see Sec. 274(n)).

Amounts included in employee’s income: The employer gets a 100% deduction if meal expense reimbursements or allowances paid for or to an employee under a nonaccountable plan are treated as compensation to the employee (Regs. Sec. 1.274-12(c)(2)(i)(A)). Of course, the employer must then pay Federal Insurance Contributions Act (FICA) taxes, and the income is subject to normal withholding. This rule basically allows employers to shift the 50% disallowance to employees. However, for 2018–2025, the employee will suffer a 100% disallowance because miscellaneous itemized deductions, including employee business expenses, are disallowed during this period (Sec. 67(g)).

Conversely, if the employee adequately accounts for the expenses and the employer properly reimburses the expenses under an accountable plan arrangement, the employer is subject to the 50% limitation on its reimbursement (Regs. Sec. 1.274-12(c)(2)(ii)). The employee has nothing to report because the reimbursement offsets the expenses incurred.

Similarly, meal reimbursements and allowances that are included in the taxable income of independent contractors (via reporting on Form 1099-NEC, Nonemployee Compensation) are also 100% deductible by the service recipient (Regs. Sec. 1.274-12(c)(2)(ii)(C)).

Nonemployee prizes and awards: The taxpayer gets a 100% deduction if expenses for meals and entertainment are includible in gross income of a nonemployee recipient as a prize or award, when a Form 1099 is issued to the recipient. No 50% disallowance applies at any level. For example, as a sales promotion, a sole proprietor holds a drawing and awards to a customer a $750 dinner cruise for 10 people. If a Form 1099 is properly issued, the proprietor gets a 100% deduction (Regs. Sec. 1.274-12(c)(2)(i)(B)).

Amounts billed to clients: When services are provided as an independent contractor, the service provider can deduct 100% of job-related meal expenses by billing the client separately for these costs. The client is then subject to the 50% disallowance rule for payments to the service provider representing reimbursements for such expenses (Regs. Sec. 1.274-12(c)(2)(ii)(C)).

If separate billing does not occur, the meal reimbursements and allowances are included in the income of the service provider and are 100% deductible by the client. Here, the 50% disallowance rule applies to the service provider.

Example 7. Determining which taxpayer is subject to 50% disallowance rule for reimbursed expenses: An advertising agency separately accounts and bills for meal and entertainment expenses and is reimbursed by the clients to whom the expenses relate. The ad agency is not subject to the 50% limitation; rather, the clients to whom the expenses are billed must apply the limitation.

Variation: Assume instead that the ad agency incurs expenses for meals and entertainment in the course of providing services to its clients but does not separately account for the expenses and seek reimbursement from its clients. (Rather, these costs are combined with service fees on billing statements presented to clients.) The ad agency itself is subject to the 50% limitation for meals and 100% limitation for entertainment expenses.

For the benefit of employees: If an employer sponsors recreational, social, or entertainment gatherings primarily for the benefit of rank-and-file (rather than highly compensated) employees, the 50% disallowance rule does not apply to related meal expenses. Examples include company outings (such as a summer picnic) and banquets or other gatherings (such as an annual Christmas party) for employees and their guests (Regs. Sec. 1.274-12(c)(2) (iii)). Free food and beverages provided in a break room available to all employees do not qualify and will be subject to the 50% disallowance rule (Regs. Sec. 1.274-12(c)(2)(iii)(B)(3)).

Advertising or goodwill: Expenses incurred for meals made available to the general public are 100% deductible (Regs. Sec. 1.274-12(c)(2)(iv)). This exception also applies to meals provided to potential customers as part of a sales presentation (IRS Letter Ruling 9414040). The exception does not apply when the meals and entertainment are provided on an invitation-only basis and not otherwise available to the general public (Churchill Downs, Inc., 115 T.C. 279 (2000)).

De minimis fringe benefits: When meal or beverage items provided to employees qualify as tax-free de minimis fringe benefits under Sec. 132(e), the employer can deduct 100% of the costs, even though the benefits are excluded from the employees’ taxable income. The IRS has ruled that the taxpayer must incur an “unreasonable or administratively impracticable” hindrance to account for the cost of meals for the value of the provided meals to be considered de minimis (Technical Advice Memorandum 200030001).

The 50% limitation applies to the expenses of an employer-operated eating facility described in Sec. 132(e)(2), including any expenses of providing food and beverages to employees in the facility. The limitation also applies to any expenses for meals furnished on the employer’s premises for the convenience of an employer under Sec. 119(a) (Sec. 274(n)(1)). After 2025, these expenses will be entirely disallowed (Sec. 274(o)).

Contributor

Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Closely Held C Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).