Federal tax planning for meals and entertainment expenses.
Entertaining 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.
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 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).
* Properly substantiated.
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...