Editor: Michael D. Koppel, CPA/CITP/PFS, MSA, MBA
Expenses & Deductions
Deductions for meals and entertainment expenditures are generally limited to 50% of the actual expense incurred, per Sec. 274(n). However, who is allowed to deduct the expenditures and, in turn, is subject to the limitation, can be complicated for expenditures incurred while performing services for another individual under a reimbursement arrangement.
An exception under Sec. 274(e)(3) requires the limitation to be applied to the person who actually bears the expense when an individual pays or incurs expenditures for meals and entertainment while performing services for someone else under a reimbursement or other expense allowance arrangement.
This exception is often applied in an employer/employee relationship, but it also applies to independent contractors and other nonemployees. The IRS recently issued proposed regulations (REG-101812-07) that clarify the definition of a reimbursement or other expense allowance arrangement and provide guidance on the applicability of the Sec. 274(e)(3) exception under various circumstances including employer/employee, two-party, and multiparty arrangements. Although the effective date of these regulations is on or after the date they are published as final, the IRS noted that taxpayers may currently rely on them.
Reimbursement or Other Expense Allowance Arrangement Defined
The proposed regulations adopt the position taken in Rev. Rul. 2008-23 that for purposes of Sec. 274(e)(3), reimbursement or other expense allowance arrangements include, but are not limited to, accountable plans as defined in Sec. 62(c). Under the proposed regulations, a reimbursement or other expense allowance arrangement involving employees is an arrangement under which an employee receives an advance, allowance, or reimbursement from a payer (the employer, its agent, or a third party) for expenses the employee pays or incurs in performing services as an employee. A reimbursement or other expense allowance arrangement involving persons that are not employees is an arrangement under which an independent contractor receives an advance, allowance, or reimbursement from a client or customer for expenses the independent contractor pays or incurs in performing services if either (1) a written agreement between the parties expressly provides that the client or customer will reimburse the independent contractor for expenses that are subject to the deduction limitations, or (2) a written agreement between the parties expressly identifies the party that is subject to the limitations under Regs. Secs. 1.274-2(a)–(e) and Sec. 274(n).
As indicated in the proposed regulations, the main requirement of a reimbursement or other expense allowance plan for a person other than an employer is that the individual substantiate to the reimbursing party the amount of expenses incurred. The individual can substantiate or account for actual allowable expenses by maintaining adequate records or other sufficient evidence. Adequate records include maintaining an account book, diary, log, statement of expenses, trip sheets, or bills to support the expenses. The taxpayer should have documentary evidence such as canceled checks or receipts to support the expenses incurred. Alternatively, for expenditures that are incurred while traveling away from home, under Rev. Proc. 2011-47, taxpayers can use an optional per diem rate to substantiate those business expenditures and determine the deductible amount. The per diem rate is generally equal to the sum of the applicable federal lodging expense rate and the applicable meals and incidental expense rate, as published annually by the General Services Administration. (See News Notes, p. 782.)
While substantiation is not included in the requirements for the exception for reimbursement arrangements between an employer and an employee under Prop. Regs. Sec. 1.274-2(f)(2)(iv)(B), substantiation is required under Sec. 274(d) to support any deduction taken by the employer.
Reimbursement of Meals and Entertainment for an Employer/Employee
Presuming that the substantiation requirement is met, a key question in determining whether a reimbursement or other expense allowance arrangement qualifies for the exception under Sec. 274(e)(3) is whether the employer includes the reimbursement in the employee’s compensation. If the employer includes the amount of reimbursement in employee compensation, then the employee bears the expense and can deduct the amount as an employee business expense subject to the 50% and other applicable limitations. The employer would deduct its payment to the employee as compensation expense that is not subject to the limitation. However, if the employer does not include the reimbursement in the employee’s wages, the employer deducts the expense subject to the limitation.
Independent Contractors and Sec. 274(e) Exception
The proposed regulations also clarify how the Sec. 274(n) limitation applies to independent contractors. When an independent contractor performs services for a client or customer in a reimbursement or other expense allowance arrangement and the customer then reimburses the independent contractor, the deduction limitation does not apply to the independent contractor to the extent that the independent contractor accounts for the expenditures to the client or customer. In that case, the client or customer is subject to the limitation and deducts the expenses. If, however, the independent contractor does not account for the expenditures to the customer or client, the contractor is subject to the limitation. Similar rules apply to multiparty reimbursement arrangements.
Multiparty Reimbursement Arrangements
In a typical multiparty reimbursement arrangement, an employee pays or incurs expenditures that are reimbursed by another party (an initial payer), and a third party then reimburses that initial payer in accordance with a reimbursement agreement. This situation occurs when a company leases its employees to a client to provide services. The proposed regulations state that such an arrangement must be analyzed as a series of separate two-party reimbursement arrangements. The first arrangement is between the employee and the initial payer, and the second arrangement is between the initial payer and the third party. If the initial payer accounts to the third party for the expenditures incurred by the employee, then the initial payer is not subject to the limitation, and the third party, which pays the actual expense, is subject to the limitation. However, if the initial payer does not account to the third party for the expenditures, the initial payer deducts the expenses subject to the limitation as the party that actually bears the expenses.
When analyzing the applicability of the Sec. 274(e)(3) exception, one ultimately must ask who bears the actual expense. The party that bears the expense generally is subject to the 50% limitation. An independent contractor with an arrangement with a customer or client needs to account to the customer or client for the expenses. If the expenditures are not accounted for, the party that incurred the expenditures is subject to the 50% limitation.
When taxpayers incur Sec. 274 expenditures under a reimbursement or other expense allowance agreement, reviewing the proposed regulations will help determine which party is subject to the 50% limitation.
Michael Koppel is with Gray, Gray & Gray LLP in Westwood, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or email@example.com.
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