Revenue Code 274: Rules for Business Expense Deductions

The tax code provides a framework for deducting business expenses, allowing for costs that are ordinary and necessary. However, Internal Revenue Code Section 274 places further limits on certain types of expenses to separate legitimate business costs from personal expenditures. The rules target areas where business activities and personal enjoyment often overlap.

This section of the code establishes a higher bar for deductibility, requiring more than just a general business connection. It introduces specific criteria and limitations that must be met for certain expenses to be claimed, ensuring that deductions are reserved for costs with a genuine business purpose.

Disallowed Entertainment Expenses

A change in tax law from the Tax Cuts and Jobs Act of 2017 eliminated deductions for most entertainment expenses. The cost of any activity considered to be entertainment, amusement, or recreation is no longer deductible, even if the entertainment is directly related to the active conduct of a business. The law removed previous exceptions that allowed for such deductions if business was discussed.

The Internal Revenue Service defines “entertainment” broadly to include taking a client to a sporting event, a theater performance, or a golf outing. The category also covers expenses for social gatherings like cocktail parties and trips for fishing or hunting. The cost of admission or tickets to these events, as well as expenses for renting facilities like a skybox, fall under this non-deductible category.

For example, if a business owner takes a client to a football game to discuss a contract, the cost of the tickets is not deductible. This holds true even if a business discussion takes place, as the primary nature of the activity is entertainment.

Deductible Meal Expenses

While entertainment costs are disallowed, expenses for business meals may still be deductible, subject to specific limitations. The deduction for business-related food and beverages is limited to 50% of the actual cost. After a temporary exception for 100% deductible restaurant meals in 2021 and 2022, the standard 50% limit was reinstated. This limitation reflects the view that meals contain an element of personal consumption.

To claim this deduction, several conditions must be met. First, the meal expense cannot be lavish or extravagant under the circumstances. Second, the taxpayer or an employee must be present when the food or beverages are provided. A business cannot simply pay for a client’s meal without attending and still claim the deduction.

The third condition requires that the meal be provided to a current or potential business customer, client, or consultant. It is important to distinguish these meals from entertainment. For instance, tickets to a sporting event are disallowed, but if food and beverages are purchased separately at the event, their cost could be 50% deductible if stated separately on the receipt.

Limitations on Business Gifts and Travel

The tax code also places specific monetary and situational limits on deductions for business gifts and certain types of travel. For business gifts, a taxpayer’s deduction is limited to $25 per recipient for the entire year. This means that if a business gives a client a gift basket costing $100, only $25 of that cost can be deducted.

Certain items are not included when calculating the $25 limit. Incidental costs, such as for engraving, packaging, or shipping, are not considered part of the gift’s cost and can be deducted separately. Promotional items for wide distribution, like pens with a company logo that cost $4 or less, are also not subject to the gift limitation.

For business travel, rules can limit deductions for travel outside the United States that combines business with personal vacation. In these cases, travel expenses must be allocated, and only the portion attributable to business days is deductible. Specific rules also apply to luxury water transportation, and the code disallows deductions for travel expenses when the travel itself is considered a form of education.

Substantiation and Recordkeeping Requirements

Claiming deductions for meals, gifts, and travel requires strict adherence to substantiation rules. Taxpayers must maintain detailed records to prove the business nature of these expenses. Without proper documentation, an otherwise legitimate deduction can be disallowed by the IRS.

For each expense, the taxpayer must substantiate five specific elements:

• The amount of the expense.
• The time and date the expense was incurred.
• The place or location of the expense.
• The business purpose of the expense.
• The business relationship of the individuals involved.

The required evidence can take several forms, including receipts, canceled checks, and detailed account books or logs. It is highly recommended that these records be contemporaneous, meaning they are created at or near the time of the expense. A receipt or other documentary proof is required for any lodging expense, regardless of the amount, and for any other single expense of $75 or more. This means for a business meal costing $80, a detailed receipt from the restaurant is necessary.

Exceptions to Disallowance Rules

While the rules impose broad limitations, they also contain several specific exceptions. These exceptions carve out particular types of expenses from the general disallowance of entertainment or the 50% meal limit, allowing for a full deduction.

One exception applies to expenses treated as compensation to an employee. If a business provides an award or prize that is entertainment, its cost is not limited if the value is included in the employee’s gross income on their Form W-2.

Expenses for recreational or social activities primarily for the benefit of employees who are not highly compensated are also exempt. This allows for the full deduction of costs for events like company holiday parties or annual picnics. Another exception covers items made available to the general public, such as providing free samples of a product to potential customers. Finally, the rules do not apply to expenses for meetings of a company’s board of directors, stockholders, or employees, where related meal costs may be fully deductible.