IRS Clarifies Exception To Deduction Limitations On Payments Under Expense Allowance Arrangements

The Internal Revenue Service has issued final regulations with respect to the exception to the deduction limitations on certain expenditures paid or incurred under a reimbursement or other expense allowance arrangement. The final regulations affect taxpayers who pay or receive advances, allowances, or reimbursements under such arrangements. The final regulations were published in the August 1 Federal Register.

The final regulations amend Reg. Sec. 1.274-2 (f)(2)(iv), which addresses reimbursed entertainment expenses. Generally, Code Sec. 274(a) does not allow deductions for entertainment expenses unless the taxpayer establishes that the activity involved is directly related to his or her trade or business. Code Sec. 274(n) allows only a 50 percent deduction of meal and entertainment expenses. Code Sec. 274(e)(3) provides an exception for reimbursement or other expense allowance arrangements where the taxpayer either performs services for an employer, if the employer has not treated the expenses as compensation, or performs services for someone other than the employer, if the taxpayer accounts to such person.

Proposed regulations to amend Reg. Sec. 1.274-2 (f)(2)(iv) were issued on Aug. 1, 2012, and they clarified that the rules apply to reimbursement or other expense allowance arrangements between payors (employers agents of the employer, or third parties) and employees. The proposed regulations also provided that, for reimbursement or other expense allowance arrangements between independent contractors and clients or customers, the parties involved may expressly identify the party subject to the Code Sec. 274(a) and Code Sec. 274(n) limitations. Where a party is not specified in an agreement, the limitations apply to the client if the independent contractor accounts to the client by substantiating the expenses, and to the independent contractor himself or herself if he or she does not account to the client. The final regulations adopted the terms of the proposed regulations without change, and are applicable to expenses paid or incurred in taxable years beginning after Aug. 1, 2013.

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