We have all heard it. There is no such thing as a free lunch. Alternatively, tomorrow never comes.
Anyone want to hazard a guess whether our tax code gives a free lunch to some taxpayers? Let’s examine U.S. Code – Title 26 – Subtitle A – Chapter 1 – Sub-chapter B – Part IX – § 274 – Disallowance of certain entertainment, etc., expenses (for those of you unfamiliar with legal hieroglyphics, the symbol § stands for “Section”.)
To ensure full disclosure, let me caution that we must specifically consider subsection (k), Business meals, Paragraph (1), including sub-paragraphs (A) and (B) and Paragraph (2), including sub-paragraphs (A) and (B). It is interesting to note that Paragraph (2) states
“Paragraph (1) shall not apply to…”
Paragraph (2) sub-paragraph (A) lists some of those exclusions by asserting
“…expense described in paragraph (2), (3), (4), (7), (8), or (9) of subsection (e)…”
Damn, now I have to go back several pages and look at the language in those earlier paragraphs. Does anyone know where I put the bourbon?
Before we leave the myriad exceptions, references and cross-references commonly known as the Internal Revenue Code, we must include subsection (n) in our consideration of a free lunch. It is the language in this section that mandates the well known 50% limit on the deductibility of meal expenses.
What was the question again? Oh yes. I wanted to know if I could get a free lunch. To answer this question I guess we also have to answer the corollary question, “free to who?” Should this sentence have been written as “free to whom?” Does anyone actually use “whom” anymore?
Imagine if you will three senior executives of a small manufacturing company eating lunch together at a nice mid-town restaurant. One of them picks up the tab. He turns the receipt in with his weekly expense report and gets reimbursed $140 by his employer. The receipt meets the requirements of subsection (d) which states,
“No deduction or credit shall be allowed unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense.”
As required, our benefactor dutifully wrote the names of the attendees on the back of the receipt. He further indicated that they discussed improving next quarter’s sales projections during lunch, including price modeling, blah, blah, blah. By providing this information, the executive met additional mandates of subsection (d) that require evidence of (C) the business purpose of the expense and (D) the business relationship of persons entertained.
Two of the executives got a free lunch because the third picked up the tab. The third ate free because he was reimbursed by the company. In fact, the bill for food and drinks only came to $110. As a big tipper, he customarily leaves a twenty percent tip. He did so this time, leaving six twenty dollar bills, one ten dollar bill and three ones for the meal and the tip. Somehow, when the receipt was filled in, the $133 total was rounded to $140. Gee whiz! Have I offended anyone? I know many of you are shocked at the suggestion that this ever happens.
When I resigned my Army commission, I began working for a CATV operator. For the first six weeks or so, I worked directly with one of the senior executives. Suffice it to say that he almost always ate lunch at a nice restaurant, and always with someone with whom he could have a business conversation. But those conversations never got tedious as they were nearly always liberally oiled with multiple adult beverages. As required by company policy and the tax code, he always kept his receipt and was always reimbursed. Would anyone want to estimate the frequency of similar occurrences across our country? What of the cost to taxpayers?
Have we ever questioned the whole notion of the deduction for “Meals & Entertainment?” Does it make sense that an average taxpayer, say, a shop owner in Galesburg IL or a farmer in Pulaski TN, is compelled to subsidize NFL tickets for a relatively high income executive to a luxury box in Denver CO?
Resuming our examination, we determine that the expense for this executive business lunch was properly substantiated by the receipt and the business purpose complied with all IRS requirements under the ‘directly related’ test specified in subsection (a) (1) (A). The company, therefore, deducts the amount reimbursed from their income for tax purposes, limited, of course, to 50% of the expense. Assuming a 35% tax bracket, the lunch actually cost the company $115.50, not the $140.00 reimbursement made to the executive. Nonetheless, it looks like the company didn't get away completely Scot-free.
Speaking of getting off Scot-free, there is an urban myth that the etymology of that term stems from an old English expression that applied to Scottish subjects who got off without paying the royal tax. Hence, they were Scot-free. I don’t know whether that is true but it sounds interesting.
Returning to our case study, imagine three journeyman tool & die makers, employed by that same manufacturer, eating lunch together at a local cafeteria. Feeling generous, having just won a $50 Lotto scratch off, one of our trio leads the others through the serving line and tells the cashier to put all three charges on one check. He does so and he pays the freight, totaling a whopping $27.85. Having heard that senior managers frequently get reimbursed for meals they eat while together, he decided to turn his receipt into human resources for reimbursement. He provided the names of his two co-workers on the back of the receipt and noted that they had discussed recommendations for changes to the latest die blueprint.
As an aside, our intrepid host should properly include the $50 Lotto winnings on Line 2c of the Other Income Statement for Line 21, Other Income, Form 1040, as unreported gambling winnings. Assuming this winning voucher was not the only scratch off ticket he ever bought, he could deduct the cost of any tickets he purchased on which he lost his wager, limited of course to his gambling winnings. This also assumes, of course, that he itemizes deductions. But I digress.
Back on point, we see the same circumstances as those of our three executives, albeit at a lower cost. Our generous benefactor met all IRS documentary and test requirements. Regardless, the receipt comes back with a polite note explaining that the meal is not eligible for reimbursement. I hear my smart phone buzzing now, alerting me to the tweets coming in. The polite tweets simply suggest that this is a corporate policy matter, a blue collar versus white collar situation not a tax code issue. That may be true perhaps, but read on.
Not one to give up so easily, he holds onto his receipt and attempts to deduct the cost of the meal when he prepares his tax return for the year. He knows that unreimbursed expenses for business meals can be deducted and that this particular expense met all of the requirements (documented, not extravagant, and directly related, etc.)
Educating himself on the sections of the tax code that apply to individual income tax deductions, he learns that the allowable deduction for meals is limited to 50% of the expense and that it is further limited by a threshold equal to 2% of his adjusted gross income. He also determines that he must itemize expenses in order to claim unreimbursed employee expenses.
Because he does not currently itemize, he must buy enough lunches so that 50% of the total spent creates an amount, the excess over 2% of his adjusted gross income which is also larger than his standard deduction. As a highly skilled worker, our big-hearted patron earns $45,000/year. Ignoring any other possible deductions, he calculates that he would have had to incur $14,056 in meal costs in order to realize the tax benefit of the $28 he spent for his friends.
Finally, he concedes that he simply cannot deduct the expense. That evening, he retires to the local pub with his two comrades. They draw straws to determine the designated driver. The loser nurses a diet coke while the others enjoy several adult beverages. He describes what he has learned about the tax code to his buddies including frequent use of FUBAR interspersed among several SNAFU descriptors.
What do we learn from all of this? First, lest you have forgotten the first few paragraphs of this post, enrolling in a class that teaches English as a Second Language, or perhaps a class in Cypher techniques, might prove useful if you want to read and understand the tax code. I will illustrate that point in greater detail in a future posting.
Although it seems that some can eat for free, I am compelled to ask that well known question, maybe only well known to those of you who know what a VCR player is, is it real or is it Memorex? Did anyone really eat for free?
Remember that we determined that the meal is not so much free as it is someone else’s treat. In the case of our three executives, one of whom treated the others, the company picked up $115.50 while American taxpayers picked up the remaining $24.50. But recollect the previous post. I suggested that tax largesse for anyone must necessarily be a tax cost to others.
If taxpayers picked up the balance of the check and the executive benefactor is a taxpayer, then he also paid part of the tab. The same holds true for his two colleagues. Reality suggests that a gratuitous tax benefit to some is a cost to those same individuals. Remember also the moral of the goose and the golden egg. The question is whether the cost to the system as a whole, including the recipient of the largesse, is worth the benefit received.
It also appears that the person being treated to a free lunch has some sway over whether he merits such largesse. In some cases, “hey buddy can you spare a dime?” is met with a dollar and a handshake. In others, it is met with a polite denial. But leave aside your opinion of this company’s treatment of different levels of employees. Focus instead on the tax code.
In the first example, the meal met all IRC requirements. As a result, the taxpayer (i.e. the company) was allowed to deduct the cost of the meal, subject to the 50% limit, with no other restrictions. This deduction reduced taxable income by $70.00.
In the second example, our journeyman tool maker is the taxpayer. His meal also met all IRC requirements. But his ability to deduct meal costs was subject to an additional limitation not applied to the corporate taxpayer. His total meal expense must exceed two percent of adjusted gross income before he is able to deduct dollar one. No such thing as a tax free lunch for him.
This is just one example of the hundreds of possible permutations of the various deductions, credits, and exceptions embedded in the IRC. I will write about many others over the next few months. The scope of this problem is illustrated by the following data. 2013 Form 1040 included 77 lines of information with an additional five lines designated for other specific information. Of these 82 separate entries or calculations, forty-one provide for deductions, exceptions, exclusions, credits or additional taxes.
Half! Is it just me or does anyone else deem that to be excessive?
As my namesake said, “I shall return.”