Check, Please! Deducting Reimbursed Meal Expenses
The IRS has recently dished out some guidance on deducting meal and entertainment expenses under reimbursement arrangements involving independent contractors or third-parties. While the broadcast reviews of local eateries may vary, entrepreneurs and their tax advisors will likely find these IRS regulations quite palatable.
Most entrepreneurs are painfully aware of the 50-percent limit on deducting meal and entertainment expenses: generally only half of your expenses are deductible. In situations where one party reimburses another for meal and entertainment expenses, the 50-percent deduction limit is designed to apply to only one of the parties, not both.
The new rules clarify how the 50-percent limit applies to three-party arrangements and to independent contractor-client arrangements.
An independent contractor is any person who is not an employee (such as an individual, or a company, providing services for a client).
In general, under the new rules, the 50-percent limitation falls on the party who bears the expense and receives substantiation of expenses. However, different rules apply for reimbursements made to 1) employees, and, 2) nonemployees (e.g., an independent contractor or an employee-leasing company).
A "win" for business owners is that an independent contractor (i.e., any nonemployee) can provide in a written agreement whether the client or the independent contractor will have the 50-percent deduction limitation.
These regulations follow upon previous IRS guidance issued after some earlier court decisions. They address how the 50-percent limit applies to expenses made by one person in providing services for another under a reimbursement or other expense allowance arrangement, regardless of whether the other person is an employer. Starting in 2014 (for calendar year taxpayers) these regulations are mandatory, but taxpayers generally have the option of applying them for 2013 and some prior years, too.
Talk to your advisor today to make sure you are getting the most of your deductions and that any reimbursement arrangements are properly set up.
For arrangements reimbursing expenses of employees, the IRS rules focus on identifying the party who bears the expense, instead of which party is the common law employer.
Provided the reimbursement is not treated as compensation to the employee, the party that has the 50-percent limitation is the “payor” under the reimbursement arrangement. The payor could be the employer, but it does not have to be. The payor could also be an agent of the employer or a third party (see the discussion of Third-Party Arrangements, below, for situations where a client reimburses an employer who reimbursed the employee).
Since the payor does not have to be an employer for purposes of these 50-percent limitation rules on reimbursements, the rules do not look at whether an employee arrangement is an accountable plan.
Under nonemployee arrangements (e.g., a client reimburses an independent contractor), the 50-percent limit on deducting meals and entertainment applies either to the person making the expense or the person bearing the expense, but not to both.
The party ultimately subject to the limit depends the terms of the arrangement. The IRS looks at the agreement with the client, and, whether the contractor accounts to the client for the expenses.
Option 1: Client agrees in writing to reimburse expenses. Where a written agreement expressly states that the client or customer will reimburse the independent contractor’s expenses, the party that has the 50-percent limit depends on whether the independent contractor accounts to the client for the expenses.
- If the independent contractor accounts to the client for (substantiates) the expenses, then the client (who agreed to reimburse expenses) is subject to the 50-percent limit
- To the extent the independent contractor does not account to the client, the independent contractor (who failed to account to the client) is subject to the 50-percent limit.
Allowing the parties to specify who has the 50-percent limit offers some flexibility, along with some administrative ease.
Option 2: Agreement specifies which party has the 50-percent limit. The parties may expressly state in a written agreement who will have the 50-percent limit.
Three-Party Arrangements: A Step-by-Step Analysis
Where three parties are involved, the person with the 50-percent limit is determined by looking at the arrangement as a series of two-party arrangements.
One example of a three-party reimbursement situation is where a client of an employee leasing company agrees, in a written agreement with the leasing company, to reimburse the leasing company for any substantiated reimbursements for travel expenses, including meals.
Client agrees in writing to reimburse employee leasing company. Ernest St. Paul, an employee, performs services under an arrangement in which an employee leasing company (LSG) pays Ernest a per-diem allowance for each day Ernest performs services for LSG’s client (CABE) while traveling away from home. The per diem allowance is reimbursement of Ernest’s travel expenses for food and beverages in performing services as an employee (it is not treated as compensation or wages).
In the written agreement between CABE and LSG, CABE agrees to reimburse LSG for any substantiated reimbursements for travel expenses, including meals, that LSG pays to Ernest. The LSG-CABE agreement does not state who has the 50-percent deduction limit.
Ernest performs services for CABE while traveling away from home and provides LSG with adequate substantiation of his meal expenses. LSG reimburses Ernest and delivers a copy of the substantiation to CABE. CABE pays LSG a larger amount, which includes both compensation for services and reimbursement of LSG’s payment of Ernest’s travel expenses for meals.
Here, CABE has the 50-percent limit. This three-party arrangement is analyzed in two separate steps: First, the Ernest-LSG arrangement. Second, the LSG-CABE arrangement.
Under the Ernest-LSG employee arrangement, the 50-percent limit initially falls on the payor, LSG.
Under the LSG-CABE arrangement, the LSG-CABE agreement expressly states that CABE will reimburse LSG for substantiated reimbursements for travel expenses that LSG pays to Ernest. Since LSG adequately accounts to CABE for CABE’s reimbursement, CABE has the 50-percent limitation and not LSG.
In some third-party arrangements, the employee providing the services might be directly reimbursed by the client.
Client reimburses expenses directly to employee provided by leasing company. The situation is the same as in Example 1, above, except that under the two arrangements (Ernest-LSG and LSG-CABE), Ernest provides the substantiation directly to CABE, and, CABE pays the per diem directly to Ernest. As payor, CABE is subject to the 50-percent limitation.
Remember, the IRS rules require a written agreement from the client that it will reimburse expenses.
No client agreement to reimburse expenses. The situation is the same as in Example 1, above, except that the LSG_CABE agreement does not provide that CABE will reimburse LSG for travel expenses. Even if LSG accounts to CABE for expenses, LSG (and not CABE) is subject to the 50-percent deduction limit.