On October 9, the IRS published final Treasury Regulations addressing the deduction disallowance of expenses associated with providing entertainment, business meals, and other food and beverages in the Federal Register. The final regulations, which track the proposed regulations published on February 26, 2020, preserve, with certain limitations, taxpayers’ ability to deduct 50 percent of the cost of business meals, even though the Tax Cuts and Jobs Act (“TCJA”) repealed the directly related and business discussion exceptions to the general prohibition on deducting entertainment expenditures. Treasury Regulation § 1.274-11 addresses the deduction disallowance under Section 274(a)(1) for entertainment costs. Treasury Regulation § 1.274-12 addresses the limitations on food or beverage expenses under Sections 274(k) and (n), including the application of exceptions in Section 274(e).
The TCJA’s elimination of a taxpayer’s ability to deduct 50 percent of meal and entertainment expenses meeting the directly related and business discussion exceptions took effect for tax years beginning after December 31, 2017. In 2018, IRS Notice 2018-76 provided transitional guidance on the deductibility of expenses for certain business meals and other food and beverage expenses under Section 274(a)(1). The proposed regulations largely adopted the guidance provided in Notice 2018-76, while also providing some significant updates. The final regulations made only a few substantive changes to the proposed regulations.
Prior to the enactment of the TCJA, 50 percent of expenses for entertainment was deductible if (1) the expense related directly to the active conduct of the taxpayer’s business or (2) there was a bona fide business discussion relating to the taxpayer’s business either immediately before or after the entertainment activity. TCJA repealed this statutory structure and made such expenses nondeductible. Under both prior law and the final regulations, entertainment expenses are expenditures for an activity that is generally considered entertainment or with respect to a facility used in connection with an entertainment activity. Under prior law, taxpayers were able to deduct 50 percent of club dues and fees if the taxpayer could demonstrate that the club membership was primarily used to promote the taxpayer’s business. The final regulations confirm that dues or fees paid to any social, athletic, or sporting club are fully disallowed because they are treated as items with respect to entertainment facilities. Fees for membership in any club are also not deductible, whether the club is organized for business, pleasure, recreation, or other social purpose, unless the value of the membership is imputed to the employee.
The Objective Test. For determining whether an activity is “of a type generally considered entertainment,” the final regulations adopt an objective test. The regulation’s attempt to define “entertainment” is circular and somewhat unhelpful in that it states an entertainment activity is one that is generally considered to be entertainment. However circular, the objective test creates a more administrable rule since it does not depend on subjective factors such as the enjoyment of participants. Additionally, the final regulations continue to provide that the determination of whether an activity constitutes entertainment will take into consideration the taxpayer’s trade or business. For example, attending a musical would generally be considered entertainment; however, a theater critic attending a performance for work, and not for entertainment, is permitted to deduct the costs associated with attending the performance. Similarly, expenses incurred by a scout or recruiter to attend a sporting event for professional purposes would not generally be considered entertainment expenses.
Business Meals. The final regulations treat business meals in the same manner as in Notice 2018-76 and in the proposed regulations. In a departure from longstanding prior guidance, which treated food and beverage expenses as subject to both the disallowance under Section 274(a) and the heightened substantiation requirements under Section 274(d), the final regulations provide that food and beverage expenses generally do not constitute entertainment.
However, if food or beverages are served during an entertainment activity, they will generally be considered a part of the entertainment. However, if the food and beverage expense is charged separately from the entertainment expense, whether on one or more receipts or invoices, the expense for food and beverage will not be treated as an entertainment expense and therefore will be deductible as a business expense (subject to the potential application of Sections 274(k) and (n)). The final rules are consistent with earlier guidance from Treasury and the IRS and rejects the position in the Joint Committee on Taxation summary of TCJA that food and beverages provided during an entertainment activity are nondeductible. If the food and beverage expenses are not separately charged, taxpayers are not permitted to allocate between the entertainment and the food and beverage expenses for purposes of deducting the latter. The final regulations are emphatic in requiring that an invoice or receipt for food and beverages must reflect the venue’s usual selling cost for those items or approximate a reasonable value for them.
Deduction Limitations Applicable to Expenses for Food and Beverages
The final regulations define food and beverage expenses to mean expenses for all food and beverages, whether characterized as a meal or a snack, including any delivery fees, tips, and sales tax. Of note, incidental costs, such as the expenses related to travel to the venue where food or beverage will be provided, are not included in this definition and thus are not subject to the deduction limitations in Section 274. To be deductible, Section 274(k) requires that (a) the expense was not lavish or extravagant under the circumstances and (b) the taxpayer (or the taxpayer’s employee) was present at the meal. The final regulations incorporate these requirements, as well as an additional requirement that the food or beverage must be provided to a business associate. Relying on an existing definition in the Section 162 regulations, the final regulations define a “business associate” as a “customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective.”
Food and beverage expenses that satisfy the requirements for deductibility under section 274(k) are generally subject to a 50 percent deduction limitation under Section 274(n).
Section 274(e) Exceptions to the Limitation on Deductibility of Food and Beverage Expenses
Section 274(e) provides several exceptions from the 50 percent deduction limitation, which result in full deductibility as explained by the final regulations.
Sections 274(e)(2) and 274(e)(9): Expenses Treated as Compensation or as Includible in the Income of Nonemployees. Sections 274(e)(2) and 274(e)(9) permit full deductibility of meal and entertainment expenses if the value of the expenses is properly treated as wages (in the case of employees who are not “specified individuals”) and as compensation or as a prize or award (in the case of a nonemployee). The final regulations explain that the Section 274(n) limitation on the deductibility of food and beverage expenses does not apply to expenses paid or incurred for food or beverage the value of which does not exceed the sum of the amount included in an employee’s compensation and treated as wages under Chapters 1 and 24 of the Code, respectively. In the case of a “specified individual” (i.e., an individual subject to section 16(a) of the Securities Exchange Act of 1934), the amount of expenses that may be deducted is limited to the amount treated as wages. In the case of a nonemployee, the Section 274(n) deduction disallowance does not apply to amounts treated as compensation for services rendered, as long as the income is reported on a Form 1099, as required (i.e., the amount is $600 or more).
The final regulations helpfully remove a “cliff” effect that was present in the proposed regulations. Under the proposed regulations, if the correct amount was not included in wages (or treated as compensation paid to a non-employee), the exceptions under Section 274(e)(2) and 274(e)(9) could not be used. Because determinations of fair market value (the amount that is required to be included in income) can be difficult and is often subject to dispute, this rule had the potential to disallow deductions for expenses that the taxpayer attempted to report properly. The final regulations soften this result by permitting the deduction of the amount actually treated as compensation, i.e., the rule applicable to expenses for specified individuals. The final regulations are clear, however, that if the amount required to be included in income is less than the cost of providing the benefit, the cost is nonetheless fully deductible provided that the appropriate amount was treated as income. Conversely, if no amount is required to be included in income because of the application of a statutory exclusion (such as in the case of Section 119 meals, de minimis fringe benefits, or working condition fringes), the exception is unavailable.
Section 274(e)(3): Reimbursed Expenses. The final regulations confirm yet again that, when a person performs services for another person, the deduction limitation applies only to the person that incurs the expenditure or the person who actually bears the expense, but not to both. This situation arises when a taxpayer reimburses an employee or nonemployee service provider for the costs of food and beverages incurred in connection with the performance of services. If the employer reimburses the employee for business meals and does not treat the reimbursement as additional wages, the deduction disallowance of 50 percent applies to the employer and not to the employee. Similarly, if an independent contractor adequately substantiates and accounts for food and beverage expenses to the client within the meaning of Section 274(d), the client is subject to the 50 percent deduction disallowance rather than the independent contractor.
Section 274(e)(4): Expenses for Social and Recreational Activities for Employees. Food and beverages that are provided at holiday parties, picnics, and other employer-sponsored social and recreational events for employees are also not subject to the 50 percent deduction disallowance, provided the provision of food is for the benefit of the employer’s employees generally and does not discriminate in favor of highly compensated employees. The final regulations maintain the position set forth in the proposed regulations that snacks provided at the worksite in an employee break room are not covered by this exception from the deduction disallowance, because the social aspect is only incidental and not guaranteed. The regulations give an example of a meal that is not provided for the employee’s social benefit. In a scenario where an employer invites an employee and a client to dinner, and it happens to be the employee’s birthday, the dinner party orders dessert to celebrate. Because the dinner is a business meal, the example concludes that it is not primarily for the benefit of the employee, and therefore the meal expenses do not meet the exception from deduction disallowance set forth in Section 274(e)(4). In contrast, if the employer provides dinner or a happy hour to employees primarily to celebrate employees having a birthday during a given month, the exception generally would be available if the nondiscrimination requirements are satisfied.
The final regulations also make it clear that meals provided for the convenience of the employer within the meaning of the Section 119 exclusion are not covered by the Section 274(e)(4). The social aspect of the Section 119 meal is merely incidental and, since it is for the employer’s convenience, it cannot also be primarily for the employee’s benefit. For example, a hospital requiring employees to be on-call during certain hours and providing meals to the employees during those times is doing so primarily for its convenience and not for the employees’ social benefit. Consequently, the Section 119 meal expenses are subject to the 50 percent limitation. (Note that, under Section 274(o), which is not addressed by the final regulations, Section 119 meal expenses will be fully nondeductible beginning in 2026.)
Section 274(e)(7): Items Available to the Public. Expenses for food and beverages that are provided to the general public are not subject to the 50 percent deduction limitation. The final regulations make it clear that this includes the entire expense in providing the food or beverage to the general public. For the exemption to apply, the food and beverage must be primarily consumed by the public, which means that 50 percent or more of actual or reasonably estimated consumption must be by the general public. The definition of the general public does not include employees, independent contractors, partners, or 2-percent shareholders of an S-corporation. Likewise, consistent with the government’s position (and victory) in Churchill Downs, Inc., an exclusive list of guests does not count as the general public. As explained in an example, the exemption would apply to a situation where a real estate agent provides food at open houses. The example concludes that the entire cost of the food for the open house is deductible since the real estate agent can reasonably estimate that over 50 percent of the food was consumed by potential buyers and other, unassociated real estate agents.
Section 274(e)(8): Entertainment or Items Sold to Customers. Taxpayers may deduct the full costs incurred for food or beverages that are sold to customers in bona fide transactions for adequate consideration in money or money’s worth. Money’s worth does not include payment through personal services; however, the final regulations adopt the position in the Joint Committee on Taxation’s summary of the TCJA that a restaurant or caterer may deduct the full cost of providing meals to employees for free or at a discount during their shifts if the meals are generally prepared for customers and consumed at the worksite.
Special Rules for Travel Meals. Food and beverage expenses incurred while travelling are subject to the deduction disallowances under Section 274(k) and 274(n). However, the Section 274(e) exemptions from the deduction disallowance under Section 274(e), which are discussed above, are applicable. In other words, meal expenses incurred in conjunction with travel away from home for business purposes are only 50 percent deductible, unless one of the exceptions described above applies. In addition, travel meal expenses must satisfy the heightened substantiation requirements under Section 274(d) unlike other food and beverage expenses. Under Section 274(m), travel meal expenses for spouses or dependents of the taxpayer or the taxpayer’s employees are not deductible unless the spouse or dependent is also an employee of the taxpayer, there is a bona fide business reason for their business trip, or some other deduction applies. If the expenses for spousal travel are imputed to the employee as additional income, the expenses are deductible as compensation.