Editor: Mark G. Cook, CPA, MBA
Expenses & Deductions
On Aug. 1 the IRS released final regulations (T.D. 9625) to clarify a portion of the 50% meals and entertainment deduction under Sec. 274. The final regulations apply to expenses paid or incurred in tax years beginning after Aug. 1, 2013.
The regulations aim to clarify the exception under Sec. 274(e)(3) to the 50% deduction limit prescribed in Sec. 274(n). This exception deals with taxpayers that pay or incur expenses under a “reimbursement or other expense allowance arrangement.” The final regulations define a reimbursement arrangement and lay out information on who is subject to the 50% limit in these arrangements.
Generally, Sec. 274(n) limits a taxpayer to deducting 50% of expenses for food and beverages as well as expenses considered “entertainment, amusement, or recreation.” A few exceptions to this limit are listed in Sec. 274(e). Specifically, Sec. 274(e)(3) explains that expenses a taxpayer paid or incurred under a reimbursement plan would be eligible for the full deduction by the taxpayer. Sec. 274(e)(3) goes on to outline rules for reimbursement arrangements where the services are performed for an employer, and also where services are performed for a third party.
In the case of an employee who performs services for his or her employer, the exception applies if the employer reimburses the employee for expenses paid or incurred and does not treat the reimbursement as compensation to the employee. In this case, the employee has no additional compensation and no deduction. The employer takes the deduction for the reimbursement paid, but it is limited to 50% of the expenses. The exception is available to only one party in the reimbursement arrangement. The deduction limitation still applies to the second party that ultimately bears the expense.
The exception under Sec. 274(e)(3) also applies if the taxpayer performs services for a third party other than an employer (i.e., a client or customer). Taxpayers who are not employees are referred to as “independent contractors” for Sec. 274 purposes. In an arrangement in which a client or customer reimburses an independent contractor, the deduction limits do not apply to the independent contractor. As long as the independent contractor properly substantiates the expenses according to Sec. 274(d), a full deduction is allowed. The client or customer then is limited to the 50% deduction.
The final regulations were issued to define the reimbursement arrangement for employees and independent contractors and clarify which party is subject to the 50% deduction limit.
Definition of reimbursement arrangement: There are separate definitions for reimbursement agreements for employees and independent contractors. For an employee, the regulations state that a reimbursement agreement is one “under which an employee receives an advance, allowance, or reimbursement from a payor (the employer, its agent, or a third party) for expenses the employee pays or incurs.” The regulations include not only employers but also any party that is considered a “payor” that reimburses an employee’s expenses. A payer includes an employer, an agent of the employer, or a third party.
An arrangement for an independent contractor is one in which the independent contractor
receives an advance, allowance, or reimbursement from a client or customer for expenses the independent contractor pays or incurs if either
- A written agreement between the parties expressly states that the client or customer will reimburse the independent contractor for expenses that are subject to the limitations on deductions . . . ; or
- A written agreement between the parties expressly identifies the party subject to the limitations.
Reimbursement involving employees: Where an employee pays or incurs Sec. 274 expenses and is reimbursed by his or her employer under a reimbursement arrangement, the following apply:
- The deduction limit applies to the employee if the employer treats the reimbursement as compensation.
- The deduction limitation applies to the payer if the reimbursement is not treated as compensation.
Reimbursement involving independent contractors: For arrangements involving persons who are not employees, and a written agreement between the parties does not expressly identify the party subject to the limits, the limits apply:
- To the independent contractor to the extent the independent contractor does not substantiate the expenses to the client or customer per the rules of Sec. 274(d).
- To the client or customer if the independent contractor properly accounts to the client or customer.
Multiple-party reimbursement arrangement: The IRS also realized that there are often multiple-party reimbursement arrangements that are not as clear-cut. Under the final regulations, these agreements should be viewed as separate two-party arrangements. In these situations, an employee pays the initial expense, is reimbursed by a second party (initial payer), and a third party reimburses the initial payer. These situations should be viewed as separate two-party arrangements: The first arrangement is between the employee and the initial payer. The second arrangement is between the initial payer and the third party. These separate two-party arrangements would follow the guidance described above. Examples are included in the final regulations for further illustration.
Compliance and Practitioner Guidance
Independent contractors and their advisers should be aware of the new regulations for the 50% meals and entertainment limit. Independent contractors should closely review contracts to ensure they comply with the requirements of the final regulations. It should also be noted that parties to existing contracts should review the contracts and amend them if possible to avoid the deduction limitation.
Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.