In Pursuit of the Tax-Free Meal

By Roxanne M. Spindle

Both Congress and the IRS continue to look at the tax aspects of payments for employee meals as a revenue generator. Steps range from partial to full disallowance as deductions to inclusion in employee income with penalties for failure to withhold.

Excluding the value of meals from an employee's taxable income while taking a deduction for the cost has been a significant tax saving. No wonder Congress has been systematically chipping away at the treatment of tax-free meals during the last ten years. The Deficit Reduction Act of 1984 (DEFRA) limited cash payments of supper money to actual reimbursement of meals consumed during the overtime period. The Tax Reform Act of 1986 (TRA '86) severely restricted the meal exclusion by eliminating deductions for the quiet business meal where business is not actively discussed. The rules for determining when employer reimbursements can be excluded from the employee's income were tightened in the Family Support Act of 1988.

Finally, in April 1994, the IRS Industry Specialization Program instructed agents to look closely and unfavorably at the exclusion of most overtime meals whether supplied in kind or as a cash reimbursement.

At the same time, the IRS indicated employers who failed to withhold and remit payroll taxes on overtime meals should not be able to avoid penalties by simply asserting there was a reasonable belief amounts would be excludable. At a minimum, an employer must be able to demonstrate it ascertained the applicable law and applied it to the particular facts. As a result, many employers who routinely pay overtime meal allowances may find themselves paying additional taxes and penalties for failure to withhold on overtime meals treated as excludable fringe benefits. Since the income tax deduction for the meals would not have been limited by the IRC Sec. 274(n) 50% reduction imposed on most meals, there would be no offsetting reduction of Federal income tax liability to minimize the impact of the payroll tax assessment.

Excluding Overtime Meal Allowances

Prior to 1985, many items paid to employees as fringe benefits were not treated as gross income. DEFRA amended IRC Sec. 61(a) to include many fringe benefits in the definition of gross income. Related code sections also were amended to make includable fringe benefits subject to FICA, FUTA (unemployment), and withholding of Federal income taxes. At the same time, DEFRA added IRC Sec. 132 to provide that certain fringe benefits would be excluded by statute from gross income. Excluded benefits are not subject to FICA, FUTA, and withholding.

IRC Sec. 132 excludes the following from an employee's gross income:

* Services provided by the employer at no additional cost, such as standby air transportation.

* Qualified employee discounts.

* Working condition fringes.

* De minimis fringes.

* Qualified transportation fringes.

* Qualified moving expense reimbursements.

Occasional overtime meals, whether reimbursed or provided in-kind, are one of the excludable de minimis fringe benefits. Overtime meals excluded under this section are deductible in full to the employer, without regard to the 50% reduction for meals, and are not subject to payroll tax withholding.

Overtime Meals

The regulations under IRC Sec. 132 allow both meals provided in kind and cash reimbursements for overtime meal money to be excluded from the employee's income if‹

* provided on an occasional basis;

* provided to enable the employee to work overtime; and

* the meal (whether provided in-kind or as meal money) is consumed during the period the employee works overtime;

These criteria must be applied on an employee-by-employee basis.

Of the three criteria, occasional basis is the most difficult to define. Whether or not the meal or meal money is occasional is determined by the frequency, "i.e., the availability of the benefit and the regularity with which the benefit is provided." This regulation also provides that frequency must be measured on an employee-by-employee basis and specifically states that meals or meal money provided on a regular or routine basis are not considered occasional. Neither regular nor routine, however, are defined further.

IRS Instructions to Examiners

In 1994, the IRS released a coordinated issue paper through its Industry Specialization Program targeting overtime meals as a potential exam issue. The paper includes an extensive review of the history of the exclusion of meal allowances and focuses on the importance of the occasional criteria, concluding that determining if a benefit is provided on an occasional basis must be done on a case-by-case basis taking into account the availability, regularity, and routine with which the benefit is provided.

The IRS paper holds that meal money may be occasional and potentially excludable only if the employee's receipt of meal money is at the discretion of the employer. If it is the employer's policy to pay a meal allowance based upon a preidentified factual pattern or preexisting entitlement program or rule, whether written or unwritten, then further analysis is warranted. Examiners are advised to analyze both union contracts and nonunion policy statements for overtime meal policies. The paper implies agents should disallow an exclusion whenever it is paid routinely as part of a union contract or general office policy.

The paper requires examiners to review accounting procedures and develop a full audit trail for this area. It reminds examiners that it is possible to reconstruct the frequency with which overtime meal money has been paid through examination of payroll and personnel records. It also notes that statistical sampling of petty-cash vouchers and payroll data has been used successfully to project total overtime by employee and average cost of a meal allowance or reimbursement. Once again, it implies agents should use these methods to determine the frequency and size of payments whenever established policies exist.

Payroll Tax Withholding

For the purposes of FICA, FUTA, and income tax withholding, wages include all remuneration for employment, including the cash value of remuneration received in kind, unless specifically excluded. If the examiner concludes overtime meals should have been included in wages, the next step is to assess the employer for failure to withhold and to seek payment of both the employer's and employees' shares of these taxes.

Among the specific exclusions from wages is the ability to exclude the value of a benefit from wages if, "at the time the benefit is provided, it is reasonable to believe that the employee will be able to exclude such benefit under IRC Sec. 132." The IRS has been reluctant to issue any guidance on whether a set number of reimbursements or the existence of a particular statement of overtime policy establishes a definitive situation in which meal allowances will be automatically denied fringe benefit treatment. Therefore, it is likely employers will argue that failure to withhold and pay employment taxes (on amounts determined under audit to not qualify as excludable) was reasonable due to the lack of clear guidance from the IRS.

The coordinated issue paper discusses the employer's liability for withholding on amounts that are disallowed as de minimis fringe benefits. It concludes that the existence of a reasonable belief for excluding benefits must be based on a reasoned judgment. Once again, the paper implies, but does not overtly state, that any company paying overtime meals as part of a union contract or automatic office policy should know such meals cannot be excluded. Therefore, it appears the IRS feels there is no reasonable cause for failure to withhold.

Estimating the Risks of Audit

Employers who routinely pay overtime meals allowances need to assess their exposure to this issue. Employers who give cash without requiring substantiation that a meal was consumed during the overtime period should include such payments in the employees' income and treat such payments as part of the payroll tax base, regardless of the frequency of payment. Some employers who only provide meals in kind or reimburse documented expenditures may find their payments of meal allowances are so routine and frequent that excluding them from income under IRC Sec. 132 is reckless at best.

The mere existence of the coordinated issue paper increases the chance of having the issue raised on audit. Since the paper was disseminated, an employee within the Industry Specialization Program reports having received "some" requests for more information on this issue. Examiners, however, have wide latitude as to what issues are addressed in any individual audit and how vigorously they are pursued. Therefore, any employer who can demonstrate it made a reasoned judgment, at the time the benefit was provided, that it was reasonable to believe the employee could exclude the overtime meal allowance, should be in a better position to deflect the agent's pursuit of the issue than one who has ignored it. This is, by no means, a sure thing, because as indicated earlier, the IRS will be looking to challenge the position wherever it can. It has taken the position in some cases that there is no reasonable basis for exclusion.

Excluding Business Meals Reimbursed Through an Accountable Plan

The Family Support Act of 1988 limited the availability of deductions for AGI to employee business expenses reimbursed by employers under a reimbursement or other expense allowance arrangement that qualifies as an accountable plan. An accountable plan is one that requires the employee to substantiate otherwise deductible expenses and return amounts in excess of the substantiated portion within a reasonable time frame.

Only reimbursements for business expenses allowable as deductions under IRC Secs. 161-197 can be excluded from the employee's income and exempted from payroll taxes. Meals are deductible under IRC Sec. 162 only if they qualify as "ordinary and necessary" business expenses. Therefore, only meals incurred in qualifying travel status and "ordinary and necessary" business meals that meet the requirements of IRC Sec. 274 can be excluded when reimbursed through an accountable plan.

Meals During Qualifying Travel

Amounts expended for meals while traveling away from home on business are specifically allowed as ordinary and necessary business expenses under IRC Sec. 162(a). If these meals are reimbursed through an accountable plan, they can be fully excluded from an employee's income. The employee, however, must be away from home "overnight or for a period sufficient to require sleep or rest." Any reimbursement for meals during non-overnight travel must be included in income and the payroll tax base unless they can be substantiated as deductible business meals. If the employee does any business entertaining during the travel, reimbursements for the additional meals cannot be excluded from the employee's income unless they meet the requirements for business meals discussed below. The amounts paid to employees that qualify as meal reimbursement are, of course, only deductible to the extent of 50% under IRC Sec. 274(n).

The employee must substantiate the amount, time, place, and business purpose of the travel expense to have it properly excludable. If the employer chooses to pay a per diem allowance for meals, the amount deemed substantiated is equal to the lessor of the per diem paid or the Federal per diem rate established for the locality of travel, regardless of how much the employee actually spent, and receipts do not need to be provided to the employer.

However, the employer must reduce its deduction for the per diem by the 50% reduction for meals and entertainment. Amounts paid in excess of the Federal per diem must be included in the employee's income. This amount becomes part of the payroll tax base and is deductible in full by the employer as compensation. If more than the Federal per diem is spent, the excess, subject to all normal reductions and limitations, may be deductible on the employee's return.

Business Meals as Entertainment

Providing clients or potential clients with food and beverages generally has been recognized as an "ordinary and necessary" business expense. Some meals, however, for spouses, frequent meals with co-workers, and otherwise allowable meals that fail to meet the requirements of IRC Sec. 274 are frequently included incorrectly in this category.

Meals for a client's spouse are deductible only if the taxpayer can demonstrate there was a bona fide business purpose for entertaining the spouse. Rev. Rul. 63-144 indicates the deduction for the spouse's meal will be treated as ordinary and necessary only if it is "impracticable under the circumstances" to entertain the client without his or her spouse. The ruling gives the example of entertaining an out of town client whose wife has traveled with him as an ordinary and necessary expense.

Meals incurred in an everyday setting, either alone or with co-workers, are generally not treated as ordinary and necessary business expenses, even if there is substantial business discussion during the meal. The important factor seems to be the frequency with which such meals occur rather than the substance of the conversations involved. The IRS and courts have consistently denied deductions for frequent meals among co-workers even when the meetings benefit the organization as a whole. Once again there is no definitive rule as to how frequent is too frequent.

Deductions After TRA '86

Prior to 1987, an ordinary and necessary business meal could be deducted if the meal took place in an atmosphere conductive to business, whether or not business was discussed before, during, or after the meal. This was generally referred to as the "quiet business meal." TRA '86 tightened up the deductibility of business meals by subjecting them to the provisions of IRC Sec. 274 as well as the ordinary and necessary requirements. Therefore, meal reimbursements cannot be excluded from an employee's income, even if reimbursed through an accountable plan, if the requirements of IRC Sec. 274 are not met.

IRC Sec. 274 allows deductions only for business meals directly related to or associated with the active conduct of the taxpayer's trade or business. Current law also limits meal deductions to those for which the costs are not lavish, reduces the deduction by 50%, and requires either the taxpayer or the taxpayer's representative to be present during meals.

As a general rule, the directly related criteria requires active business discussion initiated by the taxpayer. The specific tests under directly related are designed to demonstrate a clear business purpose and reasonable expectation of deriving a business benefit from the meal. The associated with test requires the active business discussion to be held immediately before or after the business meal.

If the entertainment of a client or customer qualifies as a directly related entertainment expense, the regulations under IRC Sec. 274 also allow a deduction for the meals of related spouses, including the taxpayer's, as associated with entertainment as long as there is a clear business purpose for entertaining the spouse, as discussed above. The taxpayer can even deduct some of the costs of a dinner party attended by nonclients if it qualifies as associated with entertainment expense. As long as the costs are not lavish or extravagant and follow a substantial business discussion, the taxpayer may treat the proportion of the costs relating to the business guests and herself as an entertainment expense. The costs of spouses' meals also can be deducted if there is a bona fide business purpose for having the spouses included, such as the out-of-town client traveling with spouse.

Consequences of Disallowance

The tax code disallows deductions for most meals that develop goodwill and general business ties. These expenditures, however, still have considerable value to many businesses and continue despite the loss of the tax deduction. If, upon audit, the employer is deemed to have paid for a meal that does not meet the ordinary and necessary requirement or fails to obtain sufficient substantiation to meet the requirements of IRC Sec. 274, several different things may occur. The results depend on whether the payment primarily benefits the business interest of the employer or the personal interest of the employee, who the employee is, and the dollar amounts involved.

If the meal primarily benefitted the business interest of the employer, the agent should attempt to disallow the deduction in full. If the employee was merely acting as an agent for the employer and received no economic benefit, the reimbursement should not be included in his or her income. For instance, the cost of meals for clients and their spouses that were reimbursed but subsequently disallowed should not become income to the employee.

If the meal benefitted the personal interest of a nonshareholder employee, it should be deductible in full to the employer as compensation rather that being limited to 50% of cost. The employer, however, could be penalized for failure to withhold tax with respect to the payment, similar to case in the overtime meal situation. In this case, an IRS agent may feel the adjustment is not worth pursuing since the additional tax deduction may save more income taxes than are assessed through the payroll tax.

If a payment benefits the personal interest of a shareholder employee, the agent can assert the employer has made a non-deductible distribution of profits. This treatment can result in income to the employee without an offsetting deduction to the employer. *

Roxanne M. Spindle, PhD, CPA, is an assistant professor of accounting at the School of Business, Virginia Commonwealth University.

OCTOBER 1995 / THE CPA JOURNAL