The general rule under Code Section 274(n) is that a taxpayer can deduct only 50% of the cost of food, beverages, and entertainment. However, there are numerous exceptions to this rule. For example, an employer can deduct 100% of the cost of these items if they are sold to customers, or if they are incurred in connection with a recreational or social event primarily for the benefit of non-highly compensated employees (e.g., a typical company-wide summer outing or holiday party, or a tax accounting firm’s April 15 happy hour).
The subject of this post is the exception in Section 274(e)(3) which allows a 100% deduction for expenses incurred under a reimbursement or other expense allowance arrangement. The IRS recently issued proposed regulations to clarify this exception. These proposed regulations address both two-party arrangements (employee or independent contractor is reimbursed for expenses incurred on behalf of employer or client/customer) and three-party arrangements (employer is reimbursed for expenses incurred by its employee in connection with a contract between employer and client/customer).
The proposed regulations reaffirm that, although the other party or parties may deduct these costs in full, one of the parties to the transaction has to be subject to the 50% limitation. They also indicate that the parties can decide who this will be. In the case of a contract with an independent contractor, the parties can “expressly identify” in their agreement the party who will be subject to the limitation. If there is no such express identification, the independent contractor is subject to the limitation, unless the independent contractor “accounts” to the client or customer for the expense. For this purpose, an accounting could consist of a separately stated per diem allowance or a detailed list of the expenses to be reimbursed.
Thus, the proposed regulations clarify both (a) the high degree of flexibility allowing parties to specify which of them will be subject to the 50% limitation and (b) the default assignment of the 50% limitation, should the parties not specify the assignment. If parties enter into a service contract in which part of the consideration is that the service recipient pays for meals, it would appear that, to avoid surprises, the best practice would be for the parties to a service contract to specify in that contract which of them will be subject to the 50% limitation.