I once worked with an IRS agent who would only make two types of adjustments. He would make UNICAP/inventory adjustments and meal and entertainment adjustments.
If either of these items could be adjusted for a tax return, he would adjust them. It didn’t matter what else was listed on the tax return. It did not matter how diligent the taxpayer was in documenting these issues.
Many IRS SB/SE auditors are like this. They have their “go to” adjustments. Meals and entertainment expenses are usually one of them.
The reason why this is the case is that no one complies with the meal and entertainment tax deduction rules. The rules are too onerous. The rules are not in keeping with U.S. business practices. Pick your reason.
If you tax return is selected by the IRS for audit and you deducted meal and entertainment expenses, all is not lost. The Franklin v. Commissioner, T.C. Memo. 2020-127 case provides an opportunity to consider how you might approach this situation.
Facts & Procedural History
The facts and history of this case are unremarkable.
The taxpayer and his wife and son lived in California. They had a time share in Nevada.
After divorcing, the taxpayer moved to New York and then New Jersey. He remarried.
The taxpayer is an real estate investment banker. He had a full time job and his employer paid him commissions as a contractor rather than an employee.
The taxpayer had a side job:
[He] also performed real estate investment consulting for Integrated Health Centers (IHC). IHC’s business purpose was to develop a network of high quality hospitals in Lagos, Nigeria. Petitioner reported no income from his services for IHC but claimed business deductions for travel expenses and meals and entertainment expenses in connection with IHC.
The taxpayer worked from home for both jobs.
The IRS selected his tax return for audit. On audit by the IRS, the IRS proposed several adjustments. This included disallowing the taxpayer’s meal and entertainment expenses.
The taxpayer was not able to convince the IRS Office of Appeals that the expense was allowable, so the taxpayer litigated the case with the U.S. Tax Court.
Meal & Entertainment Expense Deduction
The meal and entertainment expense deduction (“M&E deduction”) is allowable pursuant to the ordinary and necessary business deduction. This is the general Sec. 162 deduction. To be deductible the expense has to be ordinary and necessary for the taxpayer’s business.
Section 274(d) provides a higher substantiation requirement for the M&E deduction:
No such deduction is allowed unless the taxpayer substantiates, by adequate records or by sufficient evidence corroborating his own statements, the amount, time and place, and business purpose for each expenditure. Sec. 274(d); sec. 1.274-5T(a), (b), and (c), Temporary Income Tax Regs., 50 Fed. Reg. 46014-46016 (Nov. 6, 1985). Adequate records for this purpose require the taxpayer to maintain an account book, log, or similar record and documentary evidence that together are sufficient to establish each element of the expenditure. Id. para. (c)(2)(i), 50 Fed. Reg. 46017. In order to be adequate, records must be prepared or maintained in such a manner that each recording of an element or expenditure is made at or near the time of the expenditure or use. Id. subdiv. (ii). While a contemporaneous log is not required to substantiate the deduction, a taxpayer’s subsequent reconstruction of his or her expenses does require corroborative evidence with a high degree of probative value to support such a reconstruction, in order to elevate that reconstruction to the same level of credibility as a contemporaneous record. Id. subpara. (1), 50 Fed. Reg. 46016.
This higher substantiation requirement is what IRS auditors rely on to adjust M&E deductions.
To meet this requirement one has to (1) have a trade or business, (2) the expense must be ordinary and necessary for that business, (3) create detailed records (amount, time, place and business purpose), (4) have created the detailed records at or close in time of the expenditure.
The detailed records and close in time elements are what gets most taxpayers (Note that truck drivers and others who travel over night may also qualify for the per diem meal rules, which are deemed to be substantiated–absent the per diem rules, one has to apply the rules in this article).
Substantiating M&E Deductions
In this case, the court describes the taxpayer’s efforts to substatntiate his M&E deduction as follows:
Petitioner also created a meal log that he submitted to respondent’s Office of Appeals after filing his petition. Petitioner’s meal log included expenses for meals at restaurants both foreign and domestic, all ranging from $50 to $300. Petitioner’s meal log included several charges for meals with his former spouse and his current spouse and asserted unconvincingly that the purpose of these meetings was to discuss real estate opportunities. Petitioner did not explain the connection between the expenses listed and his work with Northbridge Group, Northbridge Partners, or IHC.
What is wrong with the taxpayer’s efforts as described by the court?
These cases often come down to credibility. Does the auditor, appeals officer, and judge believe that you are credible. The meal log in this case included meals that were personal expenses. When dealing with M&E deductions, you cannot take any expense that could even conceivably be for a meal that was a personal expense. Doing so kills your credibility.
The meal log was not contemporaneous. The rules say the records have to be created close in time. They do not say what type of records have to be created or kept. So even a simple paper receipt and envelope system would work. Testimony describing a simple paper receipt and envelope system would probably be sufficient.
The business activity was not identified. The taxpayer had more than one business activity. The meal expenses could have been for either or both activities. The taxpayer’s records or evidence should have tied the meals to one or both of the activities.
This type of case used to be more common as taxpayers were able to deduct meal and entertainment expenses as unreimbursed employee expenses. Now, after the changes made by the Tax Cuts and Jobs Act, it is only available to businesses and those who are self-employed. This includes contractors like the taxpayer in this case.
This type of case involving a reduction to an M&E deduction is still very common.
Taxpayers who deduct meal and entertainment expenses and whose tax returns are pulled for audit should take the time to properly document their expenses. This may include going back to calendars, travel logs, credit card and bank statements, etc. The log should include the amount, time, place and business purpose for the meal. It should also cross reference the other records, such as credit card or bank statements, where possible.
While it is still an uphill battle, this type of meal log can help the IRS get comfortable with the amount of the deduction.