The American Jobs Creation Act of 2004 limits the deduction allowed for entertainment, amusement and recreation provided to certain specified individuals to amounts treated as income to the recipient for federal income tax purposes.
Pre-AJCA rule
Generally, no deduction is allowed for goods, services and facilities in connection with entertainment, amusement or recreation, unless the taxpayer proves that the expenditure is directly related to or associated with the taxpayer's trade or business.
This prohibition doesn't apply to the extent that the expenses are treated by the taxpayer, with respect to the recipient of the entertainment, amusement or recreation, as compensation to an employee on the taxpayer's income tax return and as wages to that employee for purposes of the income tax withholding rules.
Similarly, the prohibition doesn't apply to the extent that the expenses are includible in the gross income of a recipient of the entertainment, amusement or recreation who is not an employee of the taxpayer as non-employee compensation for services rendered or as a prize or award includible in the recipient's income.
Under pre-Jobs Act law, the Tax Court, in Sutherland Lumber Southwest Inc., a decision affirmed by the Eighth Circuit, interpreted the above compensation exceptions to the no-deduction rule in a way that was quite favorable to the taxpayer claiming the deduction.
The court said that the exceptions meant that if the taxpayer treated the expenditure for entertainment, amusement or recreation-related goods, services or facilities as compensation to the recipient, the taxpayer could deduct the entire cost of providing those goods, services or facilities. This was so even if the cost was greater than the amount that the recipient had to treat as income.
Thus, an employer's deduction for providing entertainment or recreation to employees or independent contractors wasn't limited to the amount properly charged to the employees or independent contractors as compensation income. Instead, a deduction was allowed for the entire cost of providing the entertainment or recreation.
Example 1: On Sept. 15, 2004, your client, a C corporation, allowed its chief financial officer to use its aircraft to fly herself and her family to the Bahamas for a vacation. The value of the flight to the CFO was $3,000, but its cost to your client was $15,000. Under the Sutherland Lumber rule, your client could deduct the entire $15,000 cost of providing the flight if the CFO treated the $3,000 as taxable income and your client treated the $3,000 as wages subject to withholding.
How the act changed the rule
Effective for expenses incurred after Oct. 22, 2004, the Jobs Act overturned the Sutherland Lumber rule with respect to the costs of entertainment, amusement or recreation-related goods, services and facilities provided by private and publicly held companies to specified individuals (defined below). This means that expenses incurred by the taxpayer are deductible only to the extent that they do not exceed the amount of the expenses includible in the compensation or gross income of the specified individual.
This means a deduction is allowed only to the extent that the expenses for entertainment, amusement or recreation-related goods, services or facilities provided to an employee who is a specified individual do not exceed the amount of the expenses that are treated by the taxpayer as compensation to that specified employee on the taxpayer's income tax return and as wages to that employee for purposes of the income tax withholding rules.
For a non-employee who is a specified individual, the deduction is allowed only to the extent that the expenses for entertainment, amusement or recreation-related goods, services or facilities do not exceed the amount of the expenses that are includible in the gross income of that non-employee as non-employee compensation for services rendered or as a prize or award includible in the recipient's income.
Example 2: The same facts apply as in Example 1, except that the expenses were incurred on Oct. 25, 2004. Your client is entitled to deduct only $3,000, i.e., the amount includible as wages in its CFO's income.
Specified individual defined
Specified individuals generally include, for both public and private companies, the following individuals:
* Officers. Officers include the president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice-president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function, and any other person who performs similar policy-making functions.
* Directors.
* 10 percent-or-greater owners.
Non-specified individuals
The rules discussed above apply only with respect to the costs of entertainment, amusement or recreation-related goods, services or facilities provided to specified individuals. The pre-Jobs Act rules continue to apply with respect to the costs of such goods, services or facilities provided to other persons. This means that the Sutherland Lumber rule continues to apply with respect to the costs of entertainment, amusement or recreation-related goods, services or facilities provided to persons who aren't specified individuals.
Example 3: On Nov. 1, 2004, your client sends nine of its sales representatives on a trip in the company airplane to the Bahamas as a reward for their sales efforts during the three-month period ending Sept. 30, 2004. None of the sales representatives are specified individuals. The total cost of the flight to your client is $30,000. The value of the flight to each sales representative is $1,000. Your client can deduct the entire $30,000 cost if each sales representative treats $1,000 as taxable income and your client treats $1,000 as wages to each subject to withholding.
Observation: Presumably, if an entertainment expense is incurred for both one or more specified individuals and one or more non-specified individuals, the expense will be allocated among the individuals. The entire part of the expense allocated to the non-specified individuals will be deductible by the taxpayer, but the expense allocated to a specified individual will be deductible only to the extent includible in the specified individual's income.
Example 4: The same facts apply as in Example 3, except that your client's vice president of sales, a specified individual, goes on the trip. The value of the trip to the vice president is $1,000, the same as the value to each of the sales representatives. Presumably, 10 percent of the expense of the flight will be allocated to each of the nine sales representatives and to the vice president. Presumably, your client can deduct $3,000 of the total expense of $30,000 for each sales representative (total of $27,000 deductible with respect to the sales representatives), but can deduct only $1,000 of the expense allocated to the vice president. Thus, your client can deduct $28,000 of the total expense of $30,000 incurred in providing the flight.
Deduction when amount includible in recipient's income exceeds amount of expenses. If the amount includible in the income of the recipient with respect to entertainment, amusement or recreation-related goods, services or facilities is more than the actual expense incurred by the taxpayer in providing that benefit to the recipient, the amount deductible is limited to the amount of the expense. This is so with respect to expenses incurred for both specified individuals and non-specified individuals.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
