Taxpayers generally are allowed to deduct the amount of ordinary and necessary expenses paid or incurred while conducting a trade or business. However, limits are applied to some expense categories when determining the deductible amount. For most meals and entertainment expenses, a 50 percent limitation applies.
Although this 50 percent limitation is the general rule, some expenses are exempt from the reduced deduction. The most common instances of 100 percent deductible meals and entertainment expenses include:
- Recreational expenses for employees
- Reimbursed meals and entertainment expenses
- Expenses treated as compensation
- Items available to the general public
Companies frequently incur costs related to employee recreation throughout the year. These costs, if not for the primary benefit of highly compensated employees, aren’t subject to the 50 percent limitation typically imposed on meals and entertainment activities. Common examples of this exception include holiday parties, companywide picnics and other social events with the primary purpose of employee entertainment.
There’s a special caveat to the employee recreation exception when highly compensated employees are involved. Any indication an activity favors these individuals over the rest of the employee base will render the entire event subject to the 50 percent limitation.
Expenses paid or incurred by a taxpayer that are reimbursed by another party also are exempt from the 50 percent limitation on meals and entertainment. A common example of an eligible reimbursement arrangement occurs when a taxpayer picks up the check at a client lunch. If the meal’s cost is ultimately included in the amount billable to the client, and the taxpayer provides the appropriate substantiation to the client, the taxpayer may be able to record a full deduction, while it falls to the client to apply the 50 percent limitation.
Expenses Included in Compensation
If the value of a meal or entertainment item is included as employee wages, that amount is allowable as a full deduction for the employer subject to appropriate withholding. Similar to the rules for expenses reimbursed by a client, it becomes the employee’s responsibility to record this deduction on his or her personal tax return. This is subject to the 50 percent limitation as well as any other applicable limitations associated with unreimbursed employee business expenses reported as an itemized deduction on Schedule A.
There are some occasions where it’s impractical to properly track and account for the cost of meals or entertainment provided to employees. The values of these de minimis fringe benefits are excludable from employee compensation, yet still allowable as a 100 percent deductible expense to the employer. Examples of de minimis fringe benefits covered under this rule include free coffee or light snacks made available to employees during the workday.
Items Available to the Public
Free food and other promotional activities offered to the general public are fully deductible. For example, the cost of cookies or soft drinks available free of charge in the lobby of a car dealership falls under this rule. Free samples offered by a bakery or candy available at the front desk of a business also are eligible expenses.
To potentially increase the allowable deduction for meals and entertainment expenses, businesses should consider setting up multiple accounts to track expenses according to the different limitations. Making this distinction on the front end can provide confidence the full deduction has been taken for eligible expenses. Businesses also should educate employees on these rules to be confident expenses are allocated to the appropriate categories.
As with all expenses, substantiation is a vital component of validating and verifying the deductibility of meals and entertainment activities. Tax law requires taxpayers to maintain contemporaneous records supporting the business purpose of each meal and entertainment event. These records should provide a description of the expenditure and include information such as total amount spent, time and location, business purpose of the activity and business relationship to the person(s) entertained.