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Business meal deductions; the bite stops here.

Business Meal Deductions The Bite Stops Here

An old story is told about three taxpayers arguing over who was going to pay for their lunch. The first, a business owner, said he should pay since he could deduct it and this save 28% of the cost. The second, a salesman, argued he should pay since he had an expense account and therefore it would cost him nothing. But the third, a government contractor, said he should pay because he could make 10% on the expenditure. That old story may not hold much laughter anymore, particularly when trying to apply current rules for meal deductions.

The Internal Revenue Code and related regulations attempt to identify when a meal becomes deductible as a business expense. However, taxpayers and tax preparers alike still have difficulty making a correct determination. Even when the tax preparer knows the correct tax treatment, communicating with the taxpayer on why the deduction is not allowed can be just as difficult a task. The objective of this article is to ease the burden of these chores by first explaining the fundamental tax principles involved and then describing how the law applies in a number of different circumstances.

Statutory Landscape

Two specific Code provisions create a tension which causes uncertainty for meal deductions. On the one hand, Section 162 permits deductions for expenditures which are ordinary, necessary, reasonable in amount, and incurred in the context of a trade or business. On the other hand, Section 262 denies any deduction for personal, living or family expenses.

When a businessman takes a client out to lunch for purposes such as closing a deal or negotiating a contract, the Section 162-262 conflict becomes most apparent. First, is the meal a qualified Section 162 deduction? To so qualify the expenditure must bear a reasonable and close proximity to the taxpayer's business activity. Or, is the meal a disqualified personal expense under Section 262? Furthermore, as there are at least two meals purchased, if Section 162 permits deduction of the client's meal, does it allow similar treatment for the businessman's meal? Assuming one or more business meals are permitted under Section 162, the expenditure must then clear the hurdles of Section 274. That is, the meal must be "directly related to" or "associated with" business.

Answers to these questions often become confusing and a source of taxpayer-tax preparer conflict. A confident answer requires an understanding of how tax law is interpreted when a fundamentally personal expenditure is also incurred in the context of a trade or business. The discussion that follows examines administrative and judicial developments on the issue.

Satutory Exceptions

Before proceeding, explicit exceptions to the conflict described should be mentioned. First, Section 119 permits taxpayers to exclude from income the cost of meals when the meal is provided on the employer's business premises and is furnished for the convenience of the employer.

Second, there are occasions when an employer provides employees with a meal such as a Christmas dinner or occasional meal money when an employee works overtime. These amounts are excluded from income under Section 132(e) as a de minimis fringe benefit.

Section 213 permits deduction for medical expenses. To the extent those expenses include meals provided by a hospital during medical treatment or meals provided by a center during treatment for alcoholism or drug addiction, they are deductible.(1)

Finally, when a taxpayer is away from home in pursuit of a trade or business, Section 162(a)(2) permits a deduction for the cost of meals. There is no requirement that the Section 274 "directly related" or "associated with" tests be met, however the 80% limitation in Section 274(n) does apply.

Section 162-262 Tension

In order for an expenditure to be deductible, it must meet the requirements of Section 162. That is, the expenditure must be ordinary, necessary and reasonable in amount. Treasury Regulation 1.162-1(a) further requires that expense items be directly connected with or pertain to the taxpayer's trade or business. Whether an expense has an adequate association with business is generally given a very liberal interpretation by taxpayers and tax preparers, which can easily lead to abuse.

Section 262 denies any deduction for personal, living or family expenses, unless other Code provisions explicitly permit them as deductions. Thus, if a meal is permitted as a business expense under Section 162, a deduction will not be denied by Section 262. Revenue Ruling 75-316(2) states that expenses will not be disallowed as business deductions merely because they are personal.

The "Nexus" Requirement

Finding a bright line litmus test to distinguish a non-deductible personal meal from a deductible business meal turns upon an understanding of the association between a meal and the business. Finding an association generally requires a facts and circumstances analysis. To understand which characteristics are most relevant several judicial decisions are reviewed.

In Richard R. and Chris E. Hankenson,(3) the court denied a doctor's deduction for 174 luncheon meetings on the basis that there was no clear connection between luncheon expenses and production of income. This was in spite of the indirect contribution of the meetings to the success of the practice.

During 1978, Hankenson frequently entertained nurses, resident physicians and practicing physicians at luncheon meetings in restaurants near the hospital where he practiced. Attendance was voluntary. Hankenson deducted the cost for lunches for himself and those in attendance. During the lunches, topics concerning general office matters and patients were discussed. The specific topic depended upon who was present at the meeting. Lunch was determined to be the most convenient time to conduct the meetings.

In justifying the meal deduction, Hankenson argued that a primary objective was to generate referrals to his oncology and hematology practice. The court, however, concluded that:

While an occasional luncheon

meeting with practicing physicians

to apprise them of current

treatment techniques for cancer

patients may be deductible as a

business expense, outlays for

meals consumed three to four

days a week, 52 weeks per year,

constitute non-deductible personal

expenses under Section 262. Furthermore,

[the] luncheon meetings were a

routine event and were not called

for a specific business purpose . . .

[and the] expense did not cross

the boundary line dividing business

from personal expenses. Petitioner

has failed to demonstrate to

us that a clear nexus exists between

the luncheon expenses and

the production of income.

The court in Hankenson noted that inherently personal expenditures do not become deductible simply because they take place in a business context. A more formidable relationship between the expense and production of income must exist in order for the expense to be deductible under Section 262.

The nexus requirement is further characterized in Moss v. Commissioner.(4) Moss was a partner in a small law firm. The members of the firm, who each carried very heavy case loads, met for lunch daily at a restaurant that was convenient to both their office and the courthouse. During these meetings the lawyers would discuss their cases and decide who would meet which court call that afternoon and the next morning. Lunchtime was chosen because the court was in recess and an evening meeting was judged less convenient. Moss deducted his meals as a business expense.

In Moss the court denied the deduction on a basis similar to that in Hankenson. The court reasoned:

Because the law allows this generous

deduction [for business

meals for both businessman and

client], which tempts people to

have more (and costlier) business

meals than are necessary, the Internal

Revenue Service has every

right to insist that the meal be

shown to be a real business necessity.

This condition is most easily

satisfied when a client or a customer

or supplier or other outsider

to the business is a guest. . . .

it is undeniable that eating together

fosters camaraderie and

makes business dealings friendlier

and easier.

The court also noted that meals involving co-workers, who presumably know each other reasonably well and do not need the "social lubrication" that a meal with an outsider provides, should not be deductible, at least not when they occur on a daily basis. Thus, in the case of Moss, lunch expense was not a necessary business expense. The expenditure while incurred in a business context was incidental to and not an essential part of business.

Section 162 requires that an expense be "incurred in" carrying on a business or profit-seeking/income-producing activity. That is, the expense must have its origin in that activity rather than directed by the personal preferences and needs of the taxpayer. United States v. Gilmore(5) clearly illustrates this issue with respect to legal expenses incurred in a divorce proceeding. Mr. Gilmore, at the time of the divorce proceeding, was president and principal officer of three General Motors franchises.

While the lawsuit was initiated by the wife, Mr. Gilmore cross-claimed for divorce. His primary objectives for defeating the claims of his wife were two-fold. First, Gilmore wished to prevent loss of controlling interest in his three corporations. Second, because of his wife's sensational and reputation damaging charges of marital infidelity, Gilmore feared that loss of the divorce might cause General Motors to exercise its right to cancel the dealer franchises. Thus, for these "business" reasons Gilmore claimed deductions for his legal expenditures.

In ruling against Gilmore, the Supreme Court's decision hinged upon the position that:

The characterization, as "business"

or "personal," of the litigation

costs of resisting a claim depends

on whether or not the claim

arises in connection with the taxpayer's

profit-seeking activities. It

does not depend on the consequences

that might result to a taxpayer's

income-producing property

from a failure to defeat the

claim. The court also noted:

For income tax purposes Congress

has seen fit to regard an individual

as having two personalities: "one

is [as] a seeker after profit who can

deduct the expenses incurred in

that search; the other is [as] a creature

satisfying his needs as a human

and those of his family but

who cannot deduct such consumption

and related expenditures."(6)

Thus, for a meal to qualify under Section 162 the expense must originate from primarily business rather than personal concerns.

The Section 274 Hurdle

Assuming a meal expense passes muster under Section 162, it must then also pass the requisites of Section 274. That section imposes several requirements which are intended by Congress to curb abuses of the meal deduction permitted under Section 162. Committee reports suggest that tests under Section 274 are imposed to require a greater proximate relationship between the expenditure and the taxpayer's trade or business than are required under the Section 162 "ordinary and necessary" limitations.(7) Specifically, the meal is only deductible to the extent it is not lavish or extravagant under the circumstances, it is directly related to or associated with business, and it claims only 80% of the permitted expenditure, assuming the costs are properly documented.

While Section 274 applies these limits specifically to entertainment, gift and travel expenses, the definition of entertainment described in Regulation 1.274-1(b) clearly encompasses the business meal. This Code section also employs the term "business associate." Regulation 1.274-2(b)(2)(iii) defines a business associate as anyone:

with whom the taxpayer could

reasonably expect to engage or

deal in the active conduct of the

taxpayer's trade or business such

as the taxpayer's customer, client,

supplier, employee, agent, partner,

or professional adviser, whether

established or prospective.

The lavish and extravagant limitation of Section 274 is strictly a facts and circumstances test. No regulations have been established, however, which identify any objective limits to that amount. The other tests of Section 274, discussed below, are covered in considerable detail by related regulations.

The Directly-Related-To

Test of Section 274

Specific meaning has been assigned by Treasury Regulations to the "directly related to" requirement of Section 274. For the directly related test to be met Regulation 1.274-2(c)(2) specifies two alternatives. The first alternative has four parts all of which must be met.

1. Taxpayer has more than a general

expectation of deriving income

or other specific business

benefit (other than goodwill)

from the person being entertained.

No specific date need be

known for the realization of that


2. During the entertainment, taxpayer

actively engaged in a business

discussion or transaction

which contributed to the potential

realization of a benefit.

3. According to the facts and circumstances

of the case, the primary

purpose of the dual

business-entertainment expense

was the active conduct of taxpayer's


4. Expenses incurred are attributable

to the taxpayer and to the

business associate.

A second option for an expenditure to qualify as being directly related requires that the expenditure be made in a clear business setting. Generally this requires that the business associate could reasonably have been expected to know that the taxpayer's primary motive is the furthering of his business objectives. Regulations state that where there are substantial distractions, such as night clubs, theaters, sporting events and cocktail parties, this option cannot apply to meet the directly related test. Furthermore, where the taxpayer meets with people other than business associates, meetings at cocktail lounges, country clubs, athletic clubs and vacation resorts will not meet the clear business setting test. An additional indicator of a clear business setting is the absence of any meaningful personal or social relationships between guest and host.(8) Regulation 1.274(c)(4) provides examples of clear business settings.

The court in St. Petersburg Bank and Trust Co. v. U.S.(9) ruled that a bank president who held cocktail and dinner parties at his home could not claim the expenses because they were not directly related under Section 274(a). Only customers, potential customers and key employees of the bank were invited. The court found that the expenditures contributed to the bank's growth, enhanced its goodwill and were clearly justified under Section 162. However, since the benefit was entirely in the nature of goodwill generated from gatherings that were ostensibly social and there was no active conduct of business, the directly related test was failed.

The Associated-With Test

If a meal expense fails the directly related test, it may still qualify if it is "associated with" the active conduct of the taxpayer's trade or business. Regulation 1.274(d)(1)(ii) qualifies a meal (as well as any other entertainment expense) if it directly precedes or follows a substantial and bona fide business discussion. The taxpayer must establish that he has a clear business purpose in making the expenditure, such as to obtain new business or to encourage the continuation of an existing business relationship. The business discussion that precedes or follows the entertainment activity must involve a specific trade or business benefit and be substantial in relation to the entertainment activity. It is not necessary, however, that more time be devoted to business than to entertainment. Generally the business discussion and entertainment activity must occur on the same day. However, regulations permit a facts and circumstances analysis where there is variance.


Section 274(e)(1)-(9) lists nine situations which need not comply with the directly related or associated with test. They must, however, continue to qualify under Section 162. The 80% limitation rule is not imposed upon these expenditures.

Costs Attributable to the


When a taxpayer pays for a business associate's meal, he must run the gamut of Sections 162 and 274 in order for the expenditure to be deductible. However, this does not cover the cost of the taxpayer's own meal. On this issue the position of the court follow a strict interpretation of the law, but the position of the IRS has been to only pursue the issue in the event of abuse.

In Sutter v. Commissioner,(10) the issue was stated this way:

When a taxpayer in the course of

supplying food or entertainment

or making other outlays customarily

regarded as ordinary and

necessary includes an amount attributable

to himself or his family,

such as the payment for his own

meals, is that portion of the expenditure

an ordinary and necessary

business expense on the one hand

or a non-deductible personal item

on the other?

The court's decision, while conditioned on a facts and circumstances analysis, stated that such expenditures are ordinarily and by their nature personal expenditures and forbidden as deductions under Section 262. In addition:

We think the presumptive non-deductibility

of personal expenses

may be overcome only by

clear and detailed evidence as to

cash instance that the expenditure

in question was different from or

in excess of that which would have

been made for the taxpayer's personal


This decision is referred to as the "Sutter Rule". As a matter of administrative convenience, the Treasury Department has stated in Revenue Ruling 63-144(11) that application of the Sutter Rule will be limited to abuse cases where taxpayers claim deductions for substantial amounts of personal living expenses.

Illustration: One of the most common meal purchases occurs when a taxpayer engaged in the pursuit of business takes a client to lunch. In order for that meal expense to be deductible within the limits of Section 162, the meal must be a tool employed by the taxpayer to achieve a business goal. As a tool, the meal expense must be viewed as being more than incidental to the taxpayer's business effort. The expenditure must be an important part. The meal for example should provide the kind of social lubrication necessary for the taxpayer to establish the kind of rapport critical to business success. Assuming it so qualified, the Section 274 tests must be met. That is, the taxpayer must have a reasonable expectation that some specific benefit will be derived (other than the production of goodwill) and during the meal substantial business discussion and/or negotiation occurs. The client should also be aware that the taxpayer has a business motive for the meal.


Distinguishing between a deductible versus non-deductible meal expenditure requires drawing a distinction between an expense that is primarily attributable to trade or business activity and one that is primarily and inherently personal. Even when the distinction can be made, communicating the reasons for the distinction can be equally as difficult. This article describes the tax principles which form the basis for making the deductible versus non-deductible distinction. Once the principles are understood, the burden of communication is eased and both taxpayer and tax preparer can rest with ease that a properly defensible conclusion to a meal deduction has been found.


(1) Your Federal Taxes, IRS Publication 17, (Rev. Nov. 1988), page 123.

(2) 1975-2 C.B. 54.

(3) TC MEMO 84200.

(4) United States Court of Appeals 758 F.2d 211 (7th Cir., 1985), cert. denied 106 S. Ct. 382 (1985).

(5) 372 U.S. 39 (1963).

(6) Ibid., as quoted from Surrey and Warren, Cases on Federal Income Taxation, 272 (1960).

(7) H.R. Rep. No. 1447, 87th Cong. 1st Sess. 20 (1961), 1962-3 C.B. at 424; S. Rep. No. 1881, 87th Cong., 2nd Sess. at 28, 1962-3 C.B. at 734.

(8) Durgom v. Commissioner, TC Memo 1974-58.

(9) 362 F. Supp. 674 (M.D. Fla. 1973) aff'd per curiam, 503 F.2d 1402 (5th Cir. 1974), cert. denied, 423 U.S. 834 (1975).

(10) 21 TC 170 (1953, acq., 1954-1 C.B. 6.

(11) 1963-2 C.B. 129.

Mark A. Turner, PhD, is an assistant professor of accounting at Stephen F. Austin State University in Nacogdoches, Texas. He received his doctorate in accounting from Memphis State University, and his research and teaching interests are primarily in the area of taxation. He has published articles in the National Public Accountant, Taxes - The Tax Magazine, Taxation for Accountants and the Journal of Accountancy.
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Author:Turner, Mark A.
Publication:The National Public Accountant
Date:Apr 1, 1990
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