Substantiating Travel and Entertainment Costs

n Townsend Industries, Inc., 342 F3d 890 (2003), the Eighth Circuit ruled that the cost of a company’s annual fishing trip was a working-condition fringe benefit and a deductible business expense. CPAs should study Townsend to help business clients substantiate (and deduct) employee entertainment costs.

BACKGROUND
Townsend Industries produced printing presses out of an Iowa factory. Each June, it held a meeting in Iowa for its sales personnel, followed by a four-day fishing trip at an Ontario resort to which factory employees also were invited, to encourage discussions between the two groups. Attendance was not mandatory, but strongly encouraged, and about half the employees attended.

Employees testified that they enjoyed the trips, but considered attendance part of their jobs. They discussed company business each day. While activities and schedules were fairly flexible, everyone attended a banquet and motivational speech. Employees testified that the business discussions improved their job performance and helped in solving specific product problems. However, Townsend maintained little contemporaneous written evidence of the discussions’ business purpose.

Audit: In 1996 and 1997 the IRS challenged the taxpayer’s treatment of the trip-related costs, contending they were wages subject to withholding.

APPLICABLE LAW
Under IRC section 132, working-condition fringe benefits can be excluded from employee gross income. This occurs when employees are provided with property or a service they could have deducted under section 162 as an ordinary and necessary business expense had they paid for it themselves.

However, section 274 limits the deduction of such business expenses. Under section 274(a)(1)(A), the cost must be “directly related” or “associated with” the active conduct of the taxpayer’s trade or business. Section 274(d) requires that any item deducted under section 162 for travel or entertainment be “substantiated” with records or other evidence to support the expense’s amount, time, place and business purpose, as well as the business relationship between the taxpayer and the persons entertained. Regulations section 1.274-2(c)(3) imposes additional requirements.

HOLDING
The Eighth Circuit concluded that the trips’ costs qualified as working-condition fringe benefits and as bona fide business expenses because the taxpayer could realistically expect to gain concrete future benefits.

Witnesses testified about specific business issues discussed and problems solved during the 1996 and 1997 trips and established their business nature. Adequate substantiation was provided via specific, detailed testimony.

CONCLUSION
Townsend should not comfort taxpayers with lax recordkeeping. The Eighth Circuit did not lower the bar—the taxpayer’s position was supported by substantial testimony. Contemporaneous written evidence is critical to ensuring a deduction for entertainment expenses, unless taxpayers are willing to litigate.

For more information see the Tax Clinic, edited by Terence Kelly, in the May 2005 issue of The Tax Adviser.

—Lesli S. Laffie, editor
The Tax Adviser