as published in Law360
Lawyers across firms and organizations play a critical role in fostering a culture of compliance. Business meal and entertainment costs are one area where developing a strong compliance culture can help minimize the risk of an audit, assessment or penalties.
In order to manage these risks, in-house counsel and firms must get up to speed and be prepared to explain the updated rules to relevant stakeholders. More importantly, these are the kinds of rules that set the tone for the company. A lackadaisical approach to compliance risks not only IRS scrutiny, but sending a message to employees that complying with the rules is not a priority.
Long Track Record
The IRS is expected to continue auditing such deductions. With permissible deduction amounts reduced, any assessment for noncompliance would be greater, as would the applicable interest and penalties.
Many states have also amended their meals-and-entertainment rules to follow federal guidelines. In some states, the change is automatic because the state incorporates the Internal Revenue Code definitions into its own tax law on a rolling basis as the federal law is amended by Congress. Other states adopt the federal rules as of a fixed date that is periodically updated.
Still other states have their own specific rules for meal-and-entertainment deductions. For example, New Jersey and New York both apply new rules to C corporations, for example, while S corporations and partnerships can still claim the 100% meals and entertainment.
Changes will continue in states that adopt the Internal Revenue Code as of a fixed date. In addition, with certain federal provisions that sunset in 2026, such as employee cafeteria and de minimus meals now deductible at 50%, there will be changes at both the deferral and state level even with no new action from congress.
All this means that organizations need to stay on top of changes at the federal and state level to ensure expenses are properly tracked, deducted and budgeted for.
At the outset, corporate counsel should convey to internal departments the importance of maintaining separate books for meals and entertainment, given their varying tax treatment. Where a company has not updated its accounting system to properly capture these expenses, it faces systematic issue that will surface come audit time.
Similarly, law firm partners must understand the new meal and entertainment deductibility rules, given that they will often be directly incurring these expenses as part of their marketing and networking activity.
More generally, it is worthwhile to scrutinize these expenditures. The cost of business meals and entertainment has effectively been increased. That cost appears, however, as a tax cost.
If a firm budgets the same amount for meals and entertainment, its total costs will actually increase. Accordingly, businesses need to assess and monitor how they track and budget for these expenses.
For firms whose revenues depend on business meals and entertainment, the consequences of this scrutiny may be lower revenues and a tougher competitive environment.
Combining Meals and Entertainment
One recurring issue is how to treat an event that has both entertainment and a meal, and how to determine what is deductible as a meal. The basic rule is that where an event includes both items, only separately stated food is deductible (at 50%) as a meal.
IRS Notice 2018-76 uses the example of a sports game. Ticket costs are entertainment and not deductible, but food purchased separately is. Likewise, the price of admission to a box seat is non-deductible, but if there is an admission charge and a separately stated food charge, then the food charge can be deducted.
Criteria for any Meal Deductions
All meal deductions must satisfy certain criteria. They bear repeating here, as the IRS did in its recent guidance.
First, under Section 162, business costs can only be expensed where they are “ordinary and necessary” to a business or trade. Taking a client out for a meal during a sales visit is one example.
Second, the expense cannot be “lavish or extravagant.” In assessing this point, there is no dollar cap.
Determination is made on a case-by-case basis. However, if a business taxpayer purchases a $2,000 bottle of wine at a client meal, for example, the case will have to be made as to why the expense is routine business practice. The taxpayer must be specific in documentation.
Third, for the meal to qualify for deduction, the business taxpayer, or an employee of the taxpayer, must be present when the food and beverages are purchased. By extension, simply picking up the tab for a client meal is not deductible.
The IRS commonly identifies and disallows deductions when they are for nonbusiness purposes. It’s a red flag when a business contact seeks to write off a meal with family or a friend.
The classic example is a meal with one’s spouse, who has no business involvement. Or an old college friend with whom there is no intent of ever pursuing business collaboration. In either case, there is no legitimate business purpose and if discovered the deduction would be disallowed.
Strategies for Savings and Compliance
In many firms’ meal and entertainment expenses are not a particularly large item. It is one, however, that has visibility to employees at different levels. Moreover, the rules laid out above provide a fairly high degree of clarity. This creates an important opening to encourage a culture of compliance.
Allowing employees to play fast and loose with the meal and entertainment deductions suggests that following the rules carefully is optional. This is especially the case where employees who have substantial meal and entertainment expenses are likely also bringing in substantial revenue, and may push back against the rules.
That attitude can lead to more serious problems in other areas where the costs may be greater. In addition, the IRS will continue to audit these expenses, and, in the absence of strict substantiation, the IRS will reflexively disallow a meal deduction altogether.
Audit-proofing expensing practices can thus save money on audit while simultaneously helping foster a broader culture of compliance.
In terms of specific compliance, meal receipts must be kept. The receipts should note the meal’s time and place, the cost, the attendees (and their respective business relationship), and the business purpose, stating, for example, “Took Jane Doe from X Company to dinner as part of sales call.”
Capturing the last two points is especially important as IRS audits routinely find they fail to be notated. Where software is purchased to aid in documentation, all employees should be trained in its use to foster reporting consistency.
Properly maintained documentation will permit a taxpayer to resolve any audit relatively easily by providing such documentation to the IRS.
In the case of accounting teams, it is important to keep separate ledgers. For example, one ledger may tally holiday parties and other statutory exceptions to the new tax law that still allow for a 100% deduction for meals and entertainment.
These include, for example, expenses treated as taxable compensation to a worker, and meal and entertainment expenses for goods and services to the public, such as courtesy tickets.
Another ledger may record meal expenses that qualify for the 50% deduction, with a third for expenses that are no longer deductible.