Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.
The law (Sec. 274(n)(1)) provides limits on deductions for food and beverages, entertainment, and entertainment facilities to 50 percent (80 percent for workers under DOT rules) of the amount that would otherwise be allowed. There are some exceptions to the general rule. But the rule applies to both expenses incurred while traveling away from home (e.g. a two-day sales trip) and to entertaining clients. The rule does not apply to expenses a taxpayer pays in performing services for another person under a reimbursement or other expense allowance arrangement. If the employer treats the reimbursement as compensation and wages, the employee may be able to deduct the expense as an employee business expense. In this case the employee is subject to the deduction limitation.
Example 1-- Fred Flood is an employee of Madison Inc. and travels out of town for a two-day sales trip. While on the trip he incurs $190 worth of meal expenses, including $50 for lunch with a customer. On his return Fred submits an expense report to Madison, along with documentation, and Madison reimburses Fred the full $190. Fred doesn't have any income, nor does he have any deductible expenses. Madison can deduct only $95 on its tax return.
Example 2--Madison has a policy of not reimbursing salesmen for out-of-town trips and entertaining clients. Instead it pays them a bonus for closed sales. Madison can deduct the full amount of any bonus. Since Fred isn't reimbursed for his expenses, he can deduct them on his personal return as an itemized deduction, but the 50%-rule applies to him and he can only deduct $95.This exception also applies if a taxpayer performs services for another person other than an employer and the taxpayer accounts to that other person. Therefore, in a reimbursement or other expense allowance arrangement in which a client or customer reimburses the expenses of an independent contractor, the deduction limitations do not apply to the independent contractor to the extent the independent contractor accounts to the client by substantiating the expenses as required by Section 274(d). On the other hand, if the independent contractor is subject to the deduction limitations, the limitations do not apply to the client.
The above situations were not new. But in a 2006 case (Transport Labor Contract/Leasing, Inc.) that involved multiple parties, the taxpayer was a leasing company (TLC) that paid truck drivers a per diem allowance that it did not treat as compensation. TLC billed the client leasing the drivers for the drivers' wages and per diem allowances, and the client paid TLC. The Tax Court applied the limitation to TLC. The Court of Appeals found that the client, not TLC, bore the limitation on the per diem expense. The case also raised the issue of the term "reimbursement or other expense allowance arrangement" and the rule with respect to accountable plans.
Under the proposed regulations (REG-101812-07), a reimbursement or other expense allowance arrangement involving employees is an arrangement under which an employee receives an advance, allowance, or reimbursement from a payor (the employer, its agent, or a third party) for expenses the employee pays or incurs in performing services as an employee. A reimbursement or other expense allowance arrangement involving persons that are not employees is an arrangement under which an independent contractor receives an advance, allowance, or reimbursement from a client or customer for expenses the independent contractor pays or incurs in performing services if either (1) a written agreement between the parties expressly provides that the client or customer will reimburse the independent contractor for expenses that are subject to the deduction limitations, or (2) a written agreement between the parties expressly identifies the party that is subject to the limitations under Sec. 1.274-2(a)-(e) and section 274(n).
The proposed regulations clarify that the rules for applying the exceptions to the Section 274(a) and (n) deduction limitations apply to reimbursement or other expense allowance arrangements with employees, whether or not a payor is an employer. Under the proposed regulations, a payor includes an employer, an agent of the employer, or a third party. For example, either an independent contractor or a client or customer may be a payor of a reimbursement arrangement. Thus, any party that reimburses an employee is a payor and bears the expense if the payment is not treated as compensation and wages to the employee.
In the case of a reimbursement or other expense allowance arrangement between an independent contractor and a client or customer that includes an agreement expressly providing that the client or customer will reimburse the independent contractor for expenses that are subject to the deduction limitations, the deduction limitations do not apply to an independent contractor that accounts to the client within the meaning of Section 274(d) and the associated regulations, but they do apply to the independent contractor and not to the client if the independent contractor fails to account to the client. Alternatively, the parties may enter into an express agreement identifying the party that is subject to the deduction limitations.
For multiple parties the proposed regulations include an example illustrating how the rules apply to multiple-party reimbursement arrangements. Multiple-party reimbursement arrangements are separately analyzed as a series of two-party reimbursement arrangements. Thus, for example, an arrangement in which (1) an employee pays or incurs an expense subject to limitation, (2) the employee is reimbursed for that expense by another party (the initial payor), and (3) a third party reimburses the initial payor's payment to the employee, is analyzed as two two-party reimbursement arrangements: one arrangement between the employee and the initial payor, and another arrangement between the initial payor and the third party. Examples illustrate that the limitations apply to the party that receives an accounting and that ultimately bears the expense.
For reimbursement arrangements involving persons that are not employees, (an independent contractor) in performing services for another person (a client or customer) under a reimbursement or other expense allowance arrangement with the person, the limitations on deductions apply to the party expressly identified in an agreement between the parties as subject to the limitations. If an agreement between the parties does not expressly identify the party subject to the limitations, the limitations apply:
Example 1--Chatham LLC provides marketing services for Madison Inc. In the course of those services Chatham reimburses its employees for out-of-town meals (no entertainment expenses are incurred). The employees provide Chatham with an expense report and adequately document their expenses. During the month of August, the total comes to $3,750. Chatham has an agreement that expressly states that Madison is the party subject to the limitation on meal expenses. In this case Chatham can deduct in full the amount it reimburses its employees. Madison can only deduct 50% of the amount reimbursed to Chatham for meals.Reimbursement or other expense allowance arrangement. The term reimbursement or other expense allowance arrangement means:
Example 2--The facts are the same as in example 1, but there is no agreement as to which party is to bear the expense limitation. In this case Chatham provides Madison with an itemized list and supporting documentation for the expenses and Madison reimburses Chatham for the full $3,750. Madison can only deduct 50% ($1,875) of the total. Chatham can deduct the full amount of the expenses (offsetting the reimbursement received).
Example 3--The facts are the same as in example 2, but Chatham does not account to Madison for the reimbursed expenses. In this case Chatham can deduct only 50% of the expenses.
(1) For purposes of an employer-employee relationship, an arrangement under which an employee receives an advance, allowance, or reimbursement from a payor (the employer, its agent, or a third party) for expenses the employee pays or incurs; andComments. If your situation involves multiple parties, you should read the proposed regulations in their entirety. The important point to keep in mind here is that if you have an customer-independent contractor relationship to avoid any confusion you should state in a written agreement which party is subject to the deduction limitation. (You should always have a written agreement with any independent contractors to forestall the IRS trying to recharacterize the relationship as an employer-employee.)
(2) For purposes customer-independent contractor, an arrangement under which an independent contractor receives an advance, allowance, or reimbursement from a client or customer for expenses the independent contractor pays or incurs if either --
(a) A written agreement between the parties expressly states that the client or customer will reimburse the independent contractor for expenses that are subject to the limitations on deductions in paragraphs (a) through (e) of this section and section 274(n)(1); or
(b) A written agreement between the parties expressly identifies the party subject to the limitations.
Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 08/10/12