IRS Proposal to Clarify Treatment of Expense Reimbursements Should be Considered by Construction Contractors

August 9, 2012

Summary of Proposed Regulation: On August 1, 2012, the IRS released a proposed rule to clarify the limitations applied to meals and entertainment expenses incurred by employers.  The proposed regulations clarify the definition of an employee expense “reimbursement” and how the deduction limitations would apply when arrangements exist between three parties.  This proposal would impact construction contractors who reimburse employees for expenses that apply under Section 274 (n).

Background: Under Section 274 (n) there are limitations on the deduction of food, beverages and entertainment activities up to 50% of the total amount.  The employer is not subject to these limitations in the case of two exceptions.  The employer may treat the reimbursement as compensation which is fully deductible for the employer.  The employee would recognize the compensation and deduct the related expense subject to the limitations.  The second exception is when the employer incurs the expenses in connection with services performed for a third party (individual or business) under a reimbursement or expense allowance arrangement.

Previous Ruling: Rev. Rul. 2008-23 issued in IRS’s May 5, 2008 Internal Revenue Bulletin clarified application of the third party exception.  In the ruling, the IRS determined that employer was not subject to limitations if the employee was submitting expenses directly to the third party, regardless of the third party not being the employee’s common law employer.  The IRS ruled that the limitation should apply to the party that ultimately bears the expenses provided that party has been provided substantiated evidence.  Substantiated evidence must include (A) the amount of such expense or other item, (B) the use of the property, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of persons using the property (section 274(d)).  Giving consideration to various scenarios, the IRS deemed that the employer would have been subject to the limitations had they not provided the third party with the necessary evidence.

Additional Facts of Proposed Regulation: Based on the background and previous circuit court rulings, the IRS has clarified the definition of “reimbursement”.  The proposed regulation uses the term “payor” rather than employer.  This is meant to convey that a reimbursement may come from a contractor, client, or other party.  A “reimbursement” to an employee is defined as an advance, allowance, or reimbursement from a payor for expenses that the employee incurs in performing services for the employer.  A “reimbursement” to an independent contractor is defined as an advance, allowance, or reimbursement from a payor as expressly defined in a written agreement between the parties.  This independent contractor’s agreement may also define the party subject to deduction limitations.

For arrangements between multiple parties, and as discussed above, the IRS will consider who bears the ultimate expense.  In the example of the employee, employer and third party in the above previous rulings section, the proposed regulation would require consideration be given in a series of two-party arrangements (employee & employer and employer & third party).

Conclusion: The intention of this proposed regulation is to provide additional clarification for treatment of meals and entertainment and who is subject to the deduction limitation under an expense reimbursement scenario.  It is imperative for construction contractors to retain necessary documentation to support meals and entertainment expenses.  In three party situations where you have determined the ultimate expense lies with the third party, ensure that you are providing the third party all the necessary evidence to support their limited deduction.

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