Meal & Entertainment Expenses, A Primer
A week ago Wednesday, the IRS issued final regulations clarifying just who is subject to the 50% limit imposed by the tax code on deductible meal and entertainment expenses (or M&E for short) when one party originally pays the expense but is reimbursed for it by another.
This seemed, then, to be a good time to address these rules since many people incur M&E either in their capacity as an employee or in their business.
To understand why these regulations are important, it is important to know that only one of the parties is intended to be subject to the limitation, and there has been controversy over just who is subject to it when more than one party is involved.
First of all, if you are an employee and your employer either does not reimburse you for M&E expenses at all or does reimburse you but treats that reimbursement as taxable compensation to you, then it is you, the employee, that is entitled to deduct those expenses but also bears the burden of the 50% deduction limit.
Because the deduction for such expenses is a miscellaneous itemized deduction, an employee only gets a tax benefit if they qualify to itemize deductions and even then only to the extent that their total miscellaneous itemized deductions exceeds 2% of their adjusted gross income.
These limitations, on top of the 50% haircut already taken, can put the employee at an economic disadvantage.
The employer, on the other hand, to the extent it has reimbursed the expenses and included the reimbursement in the employee's income, will be entitled to a 100% deduction effectively passing along the burden of the limit to the employee.
The most common employer/employer arrangement, however, is one where the employer will either advance or reimburse an employee for expenses incurred. In this case, if the reimbursement is part of a qualified accountable plan, it will not be included in the employee's compensation, and the employee has nothing to deduct since he has been paid back.
It is the employer in that case that has the deduction but must limit the M&E deduction to 50% of the amount paid.
Now, what about reimbursement arrangements involving parties that are not in an employment situation, such as when one business performs services for another business and receives reimbursement for out of pocket expenses. The final regulations address that as well.
The regulations contain a new definition of a reimbursement or other expense allowance arrangement independent of the definition for accountable plan purposes mentioned above, which applies to an employment arrangement.
The regulations also clarify that the rules for applying the 50% M&E deduction limits apply to reimbursement or other expense allowance arrangements whether or not a payer is an employer.
Thus, any party that reimburses another is a payer and bears the expense if the payment is not treated as a form of compensation to the recipient.
The regulations permit those who are a party to multiparty arrangements involving nonemployees, such as independent contractors, to provide by agreement who will be subject to the 50% limit.
Absent an agreement, the limit will apply to an independent contractor if he or she does not account for the expense properly (as per the Code) to the client, but will apply to the client or customer if the independent contractor meets the substantiation requirements.
The regulations include several examples of how this works. Wording in the regulations also suggests that for any agreements to be valid, they need to be in writing.
Even if not absolutely required, it is highly recommended that such reimbursement agreements between the parties be in writing to avoid confusion and possible question. Having it in writing eliminates any question as to who gets the deduction and bears the burden of any deduction limits.
