An exception to meals and entertainment disallowance.

Generally, business expenses for food, beverages, entertainment, amusement or recreation are limited to 50% of the amount that would otherwise be deductible. However, exceptions to the 50% limitation are found in Sec. 274(n)(2). One of the exceptions is for expenses related to recreation, social

This exception commonly applies to Christmas parties, annual picnics and summer outings for employees. It also applies to the cost of maintaining a swimming pool, golf course, etc., available to employees. These activities will qualify for the exception as long as they are primarily for the benefit of nonhighly compensated employees. The questions that arise are: (1) What does "primarily" mean? (2) What type of other social/recreational activities qualify? (3) How many employees must attend?

According to Regs. Sec. 1.2742(f)(2)(v), expenditures made under circumstances that discriminate in favor of the highly compensated employees are not primarily for the benefit of employees generally. The exception could still apply even though, due to the large number of employees involved, the activity is intended to benefit only a limited number of employees at one time.

The Tax Court addressed some of these questions in American Business Service Corp., 93 TC 449 (1989). American employed 80 to 128 permanent employees in its offices, and approximately 13,000 temporary employees who worked at customers' offices. The company chartered a boat 49 times over a two-year period, each for a one-day recreational cruise for employees, with each cruise holding 25 to 35 persons. Notice of the cruise dates were posted in the offices, and reservations were taken on a first come, first served basis. In practice, very few of the temporary employees knew of or attended the cruises (only three actually attended), since they rarely visited the taxpayer's offices. It was stipulated that "[f]ewer than one-half of the remaining attendees were owners, officers, directors, highly compensated employees, family members of the same and guests of the same ('restricted persons'), and more than one-half of such remaining attendees were permanent staff employees, and their guests, other than restricted persons."

The Tax Court held that (1) the temporary employees were to be considered employees for purposes of Sec. 274(n); and (2) the taxpayer discriminated against the temporary employees by substantially preventing them from attending the recreational facilities. However, the court also ruled that the taxpayer could nevertheless properly limit the availability of the cruises to its office employees, since it involved a reasonable employee classification that did not favor the highly compensated. Thus, the phrase "primarily for the benefit of employees" does not mean that the activity must be equally available to all employees.

Although the Tax Court did not address the issue, based on the stipulation, it would appear that 50% is a possible threshold for measuring the quantitative component of the term "primarily." The Tax Court ruled in Hilliker, TC Memo 1972-183, that the taxpayer had discriminated (i.e., did not meet the "primarily" test) when two-thirds of the use of a yacht was by "restricted persons."

In addition to recreational/social activities, other types of activities (e.g., a professional sports event and a lunch or dinner outing) may also qualify.

The question becomes, how many employees must attend? If the activity is repeated (such as a cruise), how many events must be held? If American had only one cruise of 20 people, 11 of whom were not highly compensated, would the Tax Court's holding have been the same? If an employer with an office of 500 employees takes eight employees to a social lunch (e.g., for an employee's birthday), five of whom are not highly compensated, is the lunch 100% deductible? Does it matter whether every employee is taken to lunch on his birthday? Is the lunch not deductible at all since there is no business purpose?

The Tax Court in American indicated that, if there is a reasonable classification of employees and less than 50% of the employees are highly compensated, the activity will qualify for the exception. But keep in mind that the IRS examines meal and entertainment expenses very closely. One last word of caution: in American the issue was whether the "recreational expenses for employees" exception applied. If this exception is not applicable, the deduction for the activity is disallowed in total if there is no business purpose.

Howard A. Stone, CPA, J.D., Ostrow Reisin Berk & Abrams, Ltd., Chicago, Ill.