|EARL B. JOHNSTON, CPA, is a manager in the tax research and planning group of FMC Corp. in Chicago. His e-mail address is firstname.lastname@example.org .|
ntertaining is a necessary, if expensive, part of doing business. To treat a New York client to drinks, dinner and a Broadway show can cost $500 or more for two. Meals and entertainment (M&E) expenses may be only slightly lower in cities such as Chicago, Dallas, San Francisco or Seattle. As a general rule, a company can deduct only 50% of business M&E expenses. However, careful tax planning lets companies take advantage of exceptions to this rule to increase the tax deductibility of certain M&E expenses. If a company’s M&E expenses match one of the exceptions, they are 100% deductible.
|The High Cost of
Proper recordkeeping is essential. Most companies lump M&E expenses in one type of general ledger account. The company reduces the ending balance in the account by the 50% exclusion, then claims the remainder as a tax deduction on its federal corporate income tax return. However, by separately identifying, accumulating and reporting M&E expenses that are not subject to the 50% exclusion, most companies can realize a direct tax benefit. In addition, because M&E is a permanent book/tax difference (a current-period expense a company recognizes in its financial statement calculation of net income that is never allowed as a tax deduction), increasing deductible M&E expenses will lower a company’s effective tax rate, thereby increasing its net income.
CPAs can play a valuable role in helping their employers change some accounting practices to increase M&E deductions. But first, it’s important to clearly understand what kinds of expenses are eligible for the 100% deduction.
SOME GENERAL RULES
IRC section 162 allows companies to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. Although ordinary and necessary business expenses are generally deductible, costs incurred for personal reasons are not. This distinction is hard to make with M&E expenses a company incurs to promote its business, because such expenditures have both business and personal components. Under IRC sections 274(a), 274(d) and 274(k), to be tax deductible, the M&E expenses a company incurs on behalf of clients, customers or employees must be
Directly related to the active conduct of the taxpayer’s trade or business.
Ordinary and necessary (that is, not lavish or extravagant).
In addition to the above requirements, section 274(n)(1) limits the tax deductible amount of any food, beverage, or entertainment outlay—including the costs of a facility used in connection with such activity—to 50% of the amount section 162 otherwise allows as an ordinary and necessary business expense.
Section 274(n)(2) provides several exceptions to the 50% limitation on deductible M&E expenses. The Ninth Circuit Court of Appeals recently clarified an additional exception. Specifically, the following types of M&E expenses a taxpayer incurs are not subject to the 50% tax ceiling:
Costs, including the related facilities, of recreational, social or similar activities that are mainly for the benefit of employees who are not highly compensated.
Expenses directly related to the business meetings of employees, stockholders or directors.
Expenditures included in an employee’s moving expenses that are paid or reimbursed by the employer and includable in the employee’s gross income under IRC section 82.
Expenses for meals that are excludable from an employee’s gross income as a de minimis fringe benefit under IRC section 132(e).
The cost of on-site meals an employer provides to employees under the IRC section 119 “for the convenience of the employer” guideline [ Boyd Gaming Corp. v. Comm., 177 F.3d 1096 (9th Cir. 1999)].
Example 1. An XYZ, Inc., plant traditionally invites all its employees to a Christmas party at which a buffet dinner is served. Under sections 274(n)(2)(A) and 274(e)(4), XYZ’s deductible M&E expenses for the Christmas party are not subject to the 50% limitation.
Example 2. An XYZ, Inc., manager orders box lunches for her staff as part of a departmental meeting to discuss new work procedures. Under sections 274(n)(2)(A) and 274(e)(5), XYZ’s deductible M&E expense for the lunch is not subject to the 50% limitation.
Example 3. XYZ, Inc., transfers a current employee to another XYZ location. As part of the transfer, XYZ reimburses the employee for all moving-related expenditures. Under section 82, moving expense reimbursements are includable in the employee’s gross income. Therefore, under section 274(n)(2)(D), XYZ’s deduction for the M&E portion of the moving expenses reimbursed to the employee is not subject to the 50% limitation.
DE MINIMIS FRINGE BENEFITS
Under section 132, an employee’s gross income does not include the value of company-provided de minimis fringe benefits. Section 132(e) defines this fringe as any property or service the value of which, after taking into account the frequency with which the employer provides similar fringes, is so small as to make accounting for it unreasonable or administratively impracticable. Occasional meals or meal money a company provides to an employee qualifies as a de minimis fringe benefit if the amount is reasonable and the company provides it in a manner that satisfies two conditions.
Occasional basis: The company provides the meal or meal money to the employee on an occasional basis. Meals or meal money provided to an employee on a regular or routine basis do not meet this requirement.
Overtime: The company provides the meal or meal money to an employee because overtime work necessitates an extension of the employee’s normal work schedule, and the meal or meal money enables the employee to work overtime. Meals provided on the employer’s premises that the employee consumes during the period he or she works overtime or meal money provided for meals consumed during overtime satisfy this condition [Treasury regulations section 1.132-6(d)(2)].
Example 4. An XYZ, Inc., office occasionally orders pizza for employees who work late. Employees can exclude the value of this meal from their gross income as a de minimis fringe benefit. Thus, under section 274(n)(2)(B), XYZ’s deductible M&E expense for the dinner is not subject to the 50% exclusion.
AT YOUR CONVENIENCE
IRC section 119 says an employee’s taxable gross income does not include the value of meals furnished by, or on behalf of, his or her employer if the meals are both
Provided for the convenience of the employer.
Furnished on the employer’s business premises.
Whether or not an employer-provided meal is furnished for the convenience of the employer is important for federal tax purposes because the interplay of sections 119, 132 and 274 determines whether the employer may fully deduct the cost of the meal.
Meals an employer provides as a means of disguising additional compensation to an employee are not regarded as furnished for the convenience of the employer under section 119. The IRS considers a meal as furnished for the employer’s convenience only if the company provided it for a substantial noncompensatory business reason. An employer furnishes a meal for such a reason when providing it
So the employee is available for emergency calls during his or her meal period.
Because the employee must be restricted to a short meal period and could not be expected to eat elsewhere in such a short time.
Because the employee could not otherwise secure proper meals within a reasonable meal period, such as when there are not sufficient eating facilities nearby.
Treasury regulations section 1.119-1(a)(2) says whether meals are provided for the convenience of the employer is determined by the IRS on the basis of all the facts and circumstances.
Under section 119(b)(4), all meals an employer furnishes to employees on its business premises are treated as furnished for the convenience of the employer if more than half the employees to whom the meals are furnished receive them for the employer’s convenience.
For example, Smith is a bank teller who works from 9 a.m. to 5 p.m. The bank furnishes its tellers a lunch without charge in a cafeteria it maintains on its premises to limit teller lunches to 30 minutes, as the bank’s peak workload occurs during the normal lunch period. If Smith had to obtain his lunch elsewhere, it would take him considerably longer than 30 minutes, and the bank strictly enforces the time limit. Because this rule passes the section 119 convenience of the employer test, Smith may exclude the value of the lunches the bank provides him from his gross income.
While section 119 determines whether employer-provided meals are excludable from the employee’s gross income, under Boyd Gaming, the convenience of the employer test determines whether the employer may deduct 100% of the cost of such meals under section 274(n)(2).
THE BOYD GAMING DECISION
In Boyd Gaming, a casino operator required its employees to stay on the business premises throughout their entire shift. The reasons for this policy included security and efficiency concerns, maintaining workforce control, handling business emergencies, meeting continuous customer demand and the impracticality of obtaining meals nearby. As a consequence of this stay-on-the-premises policy, Boyd Gaming provided employees with free meals at on-site cafeterias. The casino operator contended that because employees had to remain on the premises during working hours—for the business reasons stated above—it was providing meals for a “substantial noncompensatory business reason” that met the section 119 convenience of the employer test.
The Ninth Circuit Court of Appeals held that Boyd Gaming’s business concerns sufficiently justified its policy of requiring employees to stay on the premises and satisfied the convenience of the employer test. Thus, Boyd Gaming employees who received the free employer-provided meals could exclude the value of the meals from their taxable gross income.
Boyd Gaming also argued that because its employer-provided meals were for the convenience of the employer, the cost of the meals was not subject to the section 274(n)(1) deduction limitation because the meals met the exception for de minimis fringe benefits. Specifically, under section 132(e)(2), meals a company provides in an employer-operated facility are de minimis fringe benefits if the facility is located on or near the employer’s business premises, and the revenue from the facility normally equals or exceeds the facility’s direct operating costs. However, under section 132(e)(2)(B), employee meals furnished on the business premises that meet the convenience of the employer test need not also meet this operating cost test to qualify as de minimis fringe benefits.
As previously stated, the 50% tax deduction limitation does not apply if a meal expense is excludable from an employee’s gross income as a de minimis fringe benefit. In Boyd Gaming, the Ninth Circuit further held that because Boyd Gaming’s employer-provided meals met the convenience of the employer standard, the meals also qualified as a de minimis fringe benefit under section 132(e) because of the section 132(e)(2)(B) rule. Therefore, the court said Boyd Gaming was entitled to deduct 100% of the expenses associated with its employee cafeteria.
THE IRS ACQUIESCES
In 1999 the IRS announced its acquiescence to the Ninth Circuit’s Boyd Gaming decision (Announcement 99-77, 1999-32 I.R.B. 243). Although the decision had gone against the IRS, the official acquiescence indicates the IRS will follow the court’s decision in similar situations.
Example 5. An XYZ, Inc., plant provides meals to employees on the premises because workers are prohibited from leaving during their shift. The stay-on-the-premises policy results from a lack of restaurants nearby and the need to have employees available at all times for plant emergencies. Because the company provides meals to the employees for its own convenience, as defined in section 119, the meals are excludable from employees’ gross income because they qualify as de minimis fringe benefits. Based on the Boyd Gaming decision, XYZ’s on-site cafeteria expenses are not subject to the 50% M&E deduction limitation.
M&E FINANCIAL REPORTING
To maximize benefits from this tax planning opportunity, companies must adjust their chart of accounts and general ledgers at each reporting location. To minimize the amount of M&E the company’s tax preparation staff subjects to the 50% exclusion, each ledger should include M&E subaccounts for the general category of M&E subject to the 50% exclusion and for each M&E expense type not subject to the 50% exclusion. Creating and properly using subaccounts will allow a company to accurately identify and accumulate the M&E expense information on its books throughout the tax year. At yearend, the tax preparation staff will then have the information it needs to make the correct M&E schedule M-1 tax adjustment in the company’s federal income tax return.
In addition, everyone involved in paying or recording business expenses or posting the related journal entries must be informed about the different types of M&E accounts on the books. The sooner a company implements these changes in accounting procedures, the more accurate the yearend balances in the M&E subaccounts are likely to be and, thus, the greater the company’s overall tax deduction for M&E expenses.
A WIN–WIN SITUATION
Most U.S. companies incur substantial business-related M&E expenses each year. By separately identifying, accumulating and reporting the types of M&E expenses not subject to the 50% tax deduction limitation, companies will realize an immediate income tax savings. Increasing the tax deductible portion of M&E expenses also will reduce a company’s effective tax rate and increase its net income. For a company to fully benefit from this tax planning suggestion, however, new procedures must be properly implemented on the general ledger, and all accounting personnel must be trained. Although a company initially must invest time to change its M&E accounting procedures, the resulting federal income tax savings should more than justify the time spent.