Understanding Entertainment Reimbursement Regulations

Mike Burt, CPA (Aug, 2013)

Clients are always looking for ways to pay less tax.  Meals and entertainment expenses at some point usually become a hotbed topic as many clients are unaware what is subject to deduction limitations and what expenses are fully deductible in order to be properly classified.  Most businesses have some sort of expense reimbursement plan for their employees who incur these expenses performing their work, but do not fully understand how they need to be reported to the employee or as a business expense.  Some businesses even have similar arrangements with independent contractors.  The Internal Revenue Service has recently released new regulations regarding payments under expense allowance arrangements (T.D. 9625) effective August 1, 2013.

All entertainment expenses require business discussions either before, during, or after the entertainment event.  Fully deductible meals and entertainment expenses include:

  • Hotel
  • Transportation
  • Registration fees
  • Employee holiday parties, including holiday cards and decorations
  • Annual picnics
  • Employee sponsored sport teams
  • Meals and entertainment included in employees’ compensation or Form 1099 for non-employees
  • Business gifts under $25 per person per year
  • Meals provided in an employer’s sponsored eating facility if over 50% of the employees meet the “convenience of the employer test”

Some of the more common meals and entertainment expenses that are subject to the 50% deductible limitation include: 

  • Restaurant meals (a member of the business must be present for customer entertainment)
  • Business luncheons at clubs or night clubs
  • Social events
  • Sporting events or trips
  • Theater events
  • Tips for entertainment on the above
  • Meals provided in an employer’s sponsored eating facility if it is 50% or fewer employees meet the “convenience of the employer test”

For a meal to be considered furnished for the “convenience of the employer” the business must have provided it for substantial non-compensatory business reasons.  The most common meal is provided when an employer requires employees to work extended hours beyond their normal work day or on weekends.  It also happens when employers need employees available for emergency calls during their normal meal period, when the employee is restricted to a short meal period while not being expected to eat elsewhere in a short time period, or when an employee is unable to have proper meals within a reasonable time such as when eating establishments are not located nearby.

Employers decide whether to reimburse employees under an accountable plan or a nonaccountable plan.  Employee expenses reimbursed under an employer’s accountable plan are not income to the employee.  Accountable plans must meet three requirements on an employee-by-employee basis.  They must have a business connection, provide expense substantiation in a reasonable amount of time, and return any excess employer reimbursements/advances.  The employer may deduct the meals and entertainment expenses as business expenses subject to the limits mentioned above.

Arrangements between employers and employees for reimbursements, advances, or allowances not satisfying one of the three requirements above for an accountable plan will be regarded as a nonaccountable plan.  Under a nonaccountable plan the expenses the employer reimburses are reported as wages on the employee’s W-2, subject to withholding and employment taxes.  The employer deducts these reimbursements as wage expense on their books.  The employees may claim the expenses included on their W-2 on their personal return on Form 2106 or Form 2106-EZ, subject to the meals and entertainment deduction limitations.  The allowed expenses then get itemized on the employee’s Schedule A, subject to the 2% of adjusted gross income limitation that applies to most miscellaneous itemized deductions.

Sometimes businesses have arrangements for reimbursements, advances, or allowances with independent contractors for meals and entertainment or travel expenses incurred on their behalf.  When an independent contractor adequately accounts to a client or customer separately for meals and entertainment expenses the client or customer must keep records of the expenses, the client or customer is subject the 50% limitation on deducting those expenses, and does not need to report the amount to the independent contractor on a Form 1099-MISC.  When an independent contractor does not adequately account to a client or customer for meals and entertainment expenses there is no need for the client or customer to keep records for the expenses, they are 100% deductible as ordinary and necessary business expenses for the client or customer, and the client or customer must report the amounts to the independent contractor on a Form 1099-MISC if over $600 during the year.

The final regulations (T.D. 9625) effective August 1, 2013 helped clarify which parties are subject to the 50% deduction limit under Code Section 274(n) regarding allowance or reimbursement arrangements.  The regulations also provide clarification that any party reimbursing expenses under an arrangement is considered the payor, not just an employer.  The payor can be an employer, an agent of the employer, or a third party.

One of the major impacts of this new regulation is the ability to expressly identify who is subject to the 50% limitation under Code Section 274(a) and Section 274(n) when it involves a nonemployee arrangement with an independent contractor and client or customer.  If an independent contractor substantiates the expenses and no identification is expressly made as to which party is subject to the 50% limitation, then the 50% limitation will apply to the client or customer.  If an independent contractor fails to substantiate the expenses and no identification is expressly made as to which party is subject to the 50% limitation, then the 50% limitation will apply to the independent contractor.

The new regulations allow for more flexibility for businesses regarding meals and entertainment related expenses.  Please feel free to contact your Dermody, Burke & Brown tax advisor to further discuss any questions you may have.

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