Statistical Sampling Can Increase M&E Deductions

One problem that taxpayers face in claiming allowable expense deductions is the administrative costs required to properly account for them. Although the Code allows a taxpayer to deduct certain expenses incurred, to properly account for deductions, the taxpayer may have to sustain an economic cost much greater than the economic benefit. This cost-benefit disparity is problematic, because it may prevent taxpayers from following the law as intended. One area in which this problem exists is meals and entertainment (M&E). Although a majority of M&E is subject to a 50% limit, exceptions permit 100% deductibility. In an effort to facilitate the accounting for fully deductible M&E, the IRS issued Rev. Proc. 2004-29, which establishes guidelines for using statistical sampling methods to account for these expenses, whether in an original return, under examination, in litigation or in making a refund claim.

Deduction Limits

Sec. 162 allows a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. For M&E, Sec. 274(n)(1) limits the deductible amount to 50%. However, this does not encompass all M&E; the following are not so limited:

• Expenses treated as compensation to an employee (Sec. 274(e)(2));

• Expenses related to food and beverages excludible under the de minimis fringe benefit rules (Sec. 274(n)(2)(B));

• Expenses covered for events that involve a ticket (Sec. 274(n)(2)(C));

• Expenses for taxable payments or reimbursements for moving expenses (Sec. 274(n)(2)(D)); and

• Expenses for food or beverages that Federal law requires to be provided to crewmembers of certain vessels and oil platforms (Sec. 274(n)(2)(E)).

For taxpayers that incur high M&E expenses, the task of separately accounting for 100% deductible expenses often becomes administratively and economically prohibitive. Previously, the IRS denied taxpayers the use of a statistical sampling method to remedy this problem. However, it finally issued Rev. Proc. 2004-29, which not only permits the use of statistics, but also explains sampling standards that allow uniformed sampling. By using statistical sampling, the taxpayer can take deductions without incurring costs in excess of the related tax benefit.

Coordination with Sec. 132

Perhaps the most common 100% allowable M&E expense is the exception for de minimis fringe benefits. Although Rev. Proc. 2004-29 allows the use of statistical sampling, an analysis of de minimis fringe benefits cannot be accomplished solely through that method. To establish the amount of identified expenses excepted via the fringe benefit rule, a taxpayer has to determine the frequency with which it provides similar fringe benefits, on either an employee-measured basis or an employer-measured basis, as explained in Regs. Sec. 1.132-6(b). Thus, even after selecting a statistical sample, a taxpayer may have to review documentation from outside the sample and target population to identify similar fringe benefits included in employees gross incomes or excluded as a de minimis fringe benefit.

Employee-Measured Frequency

A taxpayer has to establish the frequency with which it provided similar fringes to each individual employee. After identifying the statistical sample, the taxpayer has to review the remaining target population to identify the total number of similar fringes provided to the individual employees in the sample. After conducting the review, the taxpayer may be able to increase proportionately the deductible amount of expenses in the population.

Employer-Measured Frequency

Unlike the employee-measured frequency, the employer-measured frequency establishes the frequency with which similar fringes were provided to the workforce as a whole. This method is preferred when it becomes administratively difficult to identify the employee with which a particular expense is associated. Basically, this computation takes all eligible expenses and allocates them evenly among the workforce. The analysis of cost per employee ascertains the validity of the de minimis fringe benefit exception. If the value results in an amount so small that accounting for it would be unreasonable or administratively impracticable, the taxpayer could treat all the expenses as de minimis fringe benefits, not subject to the 50% deduction limit.

However, there is a pro-rata reduction to the extent that meals are evaluated under the employee-measured frequency and fail to qualify as de minimis fringe benefits. Importantly, cash fringe benefits (other than overtime meal money and local transportation fare) are never excludible as a de minimis fringe benefit; as such, expenses for M&E reimbursed to employees under an accountable plan do not qualify as de minimis fringe benefits.

Sampling Standards

Further guidance on applying statistical sampling is found in Rev. Proc. 2004-29s appendices. They offer guidelines that provide standards for uniform statistical studies. Appendix A covers sampling plan standards and lists methods and attributes to be used within the plan. Appendix B contains sampling documentation standards. Finally, Appendix C provides technical formulas.

Conclusion

Although the Code allows a full deduction for certain M&E expenses, the associated administrative and accounting problems often barred a practical application of the rules. For years, the IRS disallowed statistical sampling methods to account for M&E. However, in Rev. Proc. 2004-29, it has set the standards to permit statistical sampling for determining these deductions. By using this procedure, taxpayers can now claim such deductions, without undue compliance costs.

From Joshua C. Ebner, CPA, MST, Oak Brook, IL