On October 3, the Internal Revenue Service (IRS) issued Notice 2018-76 (the Notice) to address the deductibility of business meals under section 274(a) of the Internal Revenue Code. The Tax Cuts and Jobs Act (the TCJA) made most entertainment expenses fully or partially non-deductible by eliminating the exception for events associated with business activities. As a result, a critical question is whether typical business meals with clients and business contacts are considered to be “entertainment” and therefore subject to the deduction disallowance. The Notice indicates that many business meals will not be considered entertainment, subject to certain conditions and until the effective date of future proposed regulations.

Background

Under the general rule of section 162(a), business expenses paid during a taxable year are deductible if such expenses are “ordinary and necessary” and incurred in carrying on any trade or business. However, before the TCJA, section 274(a)(1) generally disallowed deductions with respect to expenses for entertainment, amusement, or recreation. This disallowance was subject to a broad exception for expenses that were directly related to or associated with the active conduct of the taxpayer’s trade or business. But, entertainment and meals were generally subject to a 50% deduction limitation under section 274(n). As a result of this series of inclusions and exclusions, business meals were generally treated as deductible at a 50% level before the TCJA.

The TCJA amended section 274(a) to eliminate the exception for expenses directly related to or associated with the taxpayer’s business. As a result, most entertainment expenses are non-deductible. However, the TCJA did not define entertainment or explain whether business meals are considered entertainment. Furthermore, the legislative history of the TCJA states that taxpayers may generally continue to deduct 50% of the food and beverage expenses associated with their trade or business. Finally, section 274(k) generally provides that no deduction is allowed for the expense of any food or beverages unless the expense is not lavish or extravagant under the circumstances, and the taxpayer (or an employee of the taxpayer) is present at the furnishing of such food or beverages.

The combination of the legislative history and the language of section 274(k) suggests that business meals may not be considered entertainment. On the other hand, the regulations under section 274 define entertainment as any activity “generally considered to constitute entertainment, amusement, or recreation,” which may include activities that satisfy the “personal, living or family needs” of an employee, such as “providing food and beverages.” Treas. Reg. section 1.274-2(b)(1)(i).

Notice 2018-76

The Notice provides interim guidance regarding whether business meals are considered entertainment. The IRS indicates that future proposed regulations will provide further guidance on this issue, but that taxpayers can rely on the Notice until such proposed regulations are effective.

For the time being, taxpayers may deduct 50% of otherwise allowable business meal expenses if:

• The expense is ordinary and necessary in carrying on any trade or business, under section 162(a); 
• The expense is not lavish or extravagant under the circumstances; 
• The taxpayer or its employee(s) are present at the furnishing of the food or beverages; 
• The food or beverages are provided to a current or potential business customer, client, consultant, or similar contact; and
• For food and beverages provided during an entertainment activity, the food and beverages are purchased separately from the entertainment and stated separately on bills, invoices, and receipts.

The Notice provides examples of the application of the rules, including how the rules for separately stated food and beverages are interpreted. 

The IRS and Treasury request comments for future guidance to clarify the treatment of business meal expenses under section 274. Particularly, comments are requested regarding whether and what further guidance is needed for the treatment of entertainment and business meal expenses; whether the definition of “entertainment” in the section 274 regulations should be retained or revised; whether the objective test for what constitutes entertainment in the regulations should be retained or revised; and whether and what additional examples should be addressed. Comments must be submitted by December 2, 2018. 

Eversheds Sutherland Observations

Although the requirement that an expense not be “lavish or extravagant” was already in the tax code before the TCJA changes, there may be a new focus on what the IRS would consider to be lavish or extravagant. There is limited guidance on this subject, and context is likely critical. For example, a meal with the CEO of a major customer corporation might be viewed differently from a meal with a lower-level employee of a potential customer, and a meal in New York City might be viewed differently from a meal in an area with a lower cost of living.

The Notice limits deductible business meals to those with customers, clients, and consultants, and “similar contacts.” There will inevitably be questions regarding what constitutes a “similar contact.” For example, is a vendor in that category? Or an investor?

Finally, taxpayers will want to implement systems as soon as possible to ensure that the requirements are satisfied for deductibility. This may include, to the extent not already captured by the employer’s recordkeeping system, the attendee’s status as a current or potential customer, client, consultant, or similar contact, and ensuring that food and beverages are separately stated on the invoices when there is an event with both entertainment and food and beverages.

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