Category: Deductions & Credits Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Individual taxpayer (TP) is an independent contractor engaged in the business of consulting. TP bills clients for various expenses subject to the 50% meals and entertainment disallowance under §274(n). The issues are A) who bears the 50% disallowance, TP or his client; and B) what are the reporting requirements with respect to these expenses. Provided the expenses are adequately substantiated, the 50% disallowance (or 20% for expenses paid or incurred in 1993) is borne by the client, in other words the person making the reimbursement for the expenses. The disallowance provision was first enacted as part of the 1986 Tax Reform Act. The House Report to P.L. 99-514 (the 1986 Act) provides that in the case of a taxpayer who is reimbursed for the cost of a meal or of entertainment, the percentage reduction rule applies to the party making the reimbursement. The House Report goes on to provide an example of a salesman (an employee) who pays for a meal at which business is discussed and is ultimately reimbursed for the cost of the meal by his employer. Even though the House Report uses as an example an employer-employee situation, it is clear from the language of the Committee Report that a broader scope is intended. The Report languages the concept in terms of "a taxpayer who is reimbursed". Clearly, the choice of the term "taxpayer" as opposed to "employee" indicates inclusion of a broader class than merely that of employees alone. Further research indicates that the General Explanation of the Tax Reform Act of 1986 Prepared by the Staff of the Joint Committee on Taxation (commonly known as "The Blue Book") includes the example given by the House Committee Report and adds additional commentary which explicitly addresses the issue of independent contractors. See the attached excerpt. Note also that the Blue Book adds the requirement that the independent contractor provide the client with substantiation sufficient to satisfy §274(d). Congressional committee reports explaining a tax provision are considered authoritative expressions of the intent of Congress with respect to a given statute. Arguably, the House Committee Report is clear enough on its face. Blue Book commentary is somewhat less authoritative but is still considered a strong indicator of Congressional intent with respect to a given tax issue. Since the Blue Book explanation is directly on point and is consonant with the more authoritative House Report, it seems extremely clear to me that the person to whom services are provided bears the burden of the 50% (or 20%) disallowance provided the expenses are adequately substantiated. The second issue is how to report reimbursements on the independent contractor's Schedule C. With respect to reimbursed expenses, if the contractor makes an appropriate accounting to the person to whom services are provided (the client), the reimbursed expenses need not be included in the contractor's 1099. Regulation Section 1.6041-3 and Proposed Regulation 1.6041A-1(d)(2). The theory seems to be if the appropriate accounting is made, the client is really the taxpayer with respect to the reimbursed expenses and the independent contractor is effectively incurring the expenses on behalf of the ultimate taxpayer, the client. Under that theory, the independent contractor does not recognize the reimbursed expenses at all. Incidentally, the standard for a "proper substantiation, accounting, or documentation" in this case is set forth in §§62(c), 274(d) and their related regulations. Realistically, it is almost certainly the case that some independent contractors will find expense reimbursements included in their 1099's. It seems to me important to determine whether the client included the expense reimbursement in the 1099 through ignorance of the rules or because the client deemed the substantiation submitted to be inadequate for purposes of §62(c) and §274(d). This issue is potentially a source of tension between the independent contractor and his client. If the expenses are adequately documented, the client is the taxpayer and bears the 50% (or 20%) disallowance with respect to meals and entertainment. Also, the client will ultimately have to answer for the deductibility of the items on audit. On the other hand, if the substantiation submitted with respect to the expenses is not adequate under §§62(c) and 274(d), the 50% (or 20%) disallowance and the burden of ultimately answering for the deductibility of the expenses is born by the independent contractor. Obviously, whether the burden has been met is a question of fact, and it would be wise if the independent contractor finds expense reimbursements in his 1099 to deal with the issue when it arises, not at a later time in a tax examination. Clearly the best solution is to have the 1099 reissued without the expense reimbursements. There seems to be no guidance if the client has included reimbursements in the 1099 through ignorance of the rules and the client refuses to correct the 1099. As a practical matter, the expense reimbursements must somehow be shown on the Schedule C in order to avoid 1099 matching problems. The question becomes how to best offset the income amounts. Again there is no guidance on this issue that I can locate. Perhaps the common sense approach is to create a deduction line item on Schedule C under other deductions to deal with the offset. It seems important to me to stake out the position from the outset that these expenses represent items reimbursed under a fully substantiated arrangement, and the deduction is on the return simply to offset inappropriately included amounts of gross income. It seems to me critical to avoid characterizing these amounts as meals and entertainment or even travel expenses. It is clear that this treatment may not avoid all problems with respect to these items. The independent contractor should carefully retain all documentation submitted to the client in case the contractor ultimately is required to prove that the expenses were reimbursed pursuant to adequate substantiation under §§62(c) and 274(d). |
