Is that business lunch of yours tax deductible?
I am old enough to remember the banter about three-martini business lunches and the ability for a business to claim a deduction for such lunches for tax return purposes. This point in time was of course when I had more hair, less grey and seemingly had more energy. The three-martini lunch, along with other deductions and tax credits, was on the list when the last major comprehensive tax reform took place in 1986. After the 1986 tax reform, the three-martini lunch became the 2.4-martini lunch, as only 80 percent of that lunch was otherwise deductible for tax purposes if the other requirements for a business meal were met. At the time, there was some concern over whether such expenditures were appropriate with respect to business meals and whether tax deduction limits should be placed on such expenses. Other limitations also were enacted at the same time regarding business entertainment activities.
Years later, the 2.4-martini lunch essentially became the 1.5-martini lunch, as the tax deductible amount was reduced from 80 percent to 50 percent for qualifying business meals. Of course, such lunches aren’t as common today as in the 1980s, as consuming alcohol at a business lunch is less frequent in today’s world. Internal Revenue Service (IRS) publication 463 (Travel, Entertainment, Gift, and Car Expenses) specifically addresses some of the current rules and requirements for business meals and entertainment deductions.
The key to sustaining any business deduction for tax purposes is documentation supporting the costs incurred by a business for the activity and a tax code section or regulation allowing for the deduction. For business meals, there are some specific requirements in addition to the receipt for the meal. For claiming a tax deduction for a business meal or entertainment, the expense must be necessary and ordinary and must be directly related or associated with one’s trade or business activity. There are some specific requirements for what is considered directly related or associated with one’s trade or business activity. A business that does not satisfy the documentation requirements with respect to such meals and entertainment activities can result in the disallowance of the tax deduction claimed for those expenses and an increased tax liability.
There are certain categories of business meals that may be deductible in full rather than 50 percent deductible. This may include meals related to employee overtime activities, meals related to staff meetings and meal cost related to certain employee welfare activities that are for the benefit of all employees (such as picnics or holiday parties). There are specific requirements for meeting these and other tests for obtaining a full deduction for these meals and related expenses. To assist in the reporting of these activities, many businesses have processes and procedures to track the 100 percent deductible meals to avoid classifying them as only 50 percent deductible. Given that many employee expense-reporting systems are often dependent on the employee or other staff members for identification and classification of the types of business expense incurred, this often leads to incorrect reporting for many businesses. Specifically, the difference in the requirements and rules for these deduction limitations for the different types of business meals and business entertainment items often leads to the incorrect classification, and this results in additional taxable income of the business being reported on a tax return.
Meals and entertainment is a common IRS examination item when the IRS audits a business income tax return. Documentation may be incomplete or the classification of an item as 50 percent, 100 percent or 0 percent deductible is incorrect. The challenge and opportunity for businesses are to have systems and processes in place that mitigate the likelihood of misclassification or reporting errors.
There also are issues of what is or isn’t a qualifying expense under current tax law. A recent 2017 Tax Court case involving a sports team illustrates that point. The case decided at the end of June involved the Boston Bruins hockey team. The issue dealt with group employee meals and whether such meals were entitled to a 50 percent or 100 percent deduction. Specifically, the facts involved pregame meals at away city hotels that the hockey team provided to its players and coaching and other staff members. The team arranged with away city hotels for meals to be provided to the employees before a game. The Tax Court determined the meals were provided to the team employees for substantial noncompensatory business reasons and were considered a de minimis fringe benefit under the specific Internal Revenue Code sections dealing with such items.
I enjoy reading tax cases involving sports teams. In addition to information on the team and league history, one often learns some specific insights with respect to the operation of the team and sports league. This recent Tax Court case is interesting in many respects, as it does go into detail on the typical pregame regiment and preparation a professional team participates in with its players and coaching staffs. The Tax Court decision described how the pregame meals met the requirements of a fully deductible business meal.
The taxpayer wasn’t sent to the penalty box in this recent case. The taxpayer argued their facts and applied their interpretation of the law, and the Tax Court ruled in their favor. The takeaway is to win a faceoff on this type of issue, it is important to have documentation, an understanding of the applicable tax law and have the proper classification of such expenses as provided in the Internal Revenue Code and its regulations.
The recent Tax Court decision has focused many businesses to review their own tracking, reporting and classification of business meals and entertainment expenses. A business doesn’t need to be a professional sports franchise to claim certain meals as 100 percent deductible business expenses. Many professional service firms offer services relating to the proper identification and classification of meals and entrainment expenses and the appropriate deductibility of the amounts incurred. A business may not need a shootout goal to win the game but just some good old fashion body checking in the corners of the rink. This includes reviewing documentation and classification of these types of expenses. As the summer comes to an end and the seasons change, businesses should take some time to review these types of items and score their own hat trick.
William Roth is a tax partner with the local office of international accounting firm BDO USA LLP. The views expressed above are the author's and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.