Meals and Entertainment Expense Deduction

Businesses will pay for meals and entertainment of employees to help team building, or of customers to help generate business. So, there is a real business purpose to this expense. However, only 50% of business meals and entertainment were previously deductible. However, under the new tax law, most business entertainment expenses incurred subsequent to December 31, 2017 will be considered 100% nondeductible, with the exception of expenses incurred for the benefit of the taxpayer’s employees (e.g. office holiday parties), which remain 100% deductible.

Below are examples specified by the IRS of non-deductible entertainment expense under the TCJA: Night clubs, Theaters, Country clubs, Golf and athletic clubs, Sporting events, Hunting/fishing and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family.

While several types of entertainment will no longer be deductible, a number of activities will not be affected by the code. As of now, if an employee is working overtime and the employer provides dinner money, that expense will be allowed to be deducted. If a hotel is maintained by an employer while an employee is staying there for business travel, there will not be any limits for the deduction.

Also, business meals occasionally provided to employees and for the convenience of employers are no longer fully deductible and subject to the 50% deductibility limitation under §274 for tax years 2018-2025. After 2025, such business meals will be treated as non-deductible.  Several requirements are in order to claim a business meal deduction. The meal must have happened during the taxable year for trade or business and cannot be extravagant for the event. The taxpayer or employee of the taxpayer has to be present. If the taxpayer only gives money to a client but is not actually there, that money will not count towards the deduction. The client must either be a current client or a potential client – a previous client that the taxpayer remained friends with will not be allowed.

Domestic Production Activities Deduction (DPAD)

Congress created the domestic production activities deduction (DPAD) in an effort to encourage manufacturing plants to locate in the United States. Basically, it’s a subsidy for the cost of producing goods, some construction services, filmmaking, and other specified industries in the United States.

It’s a complex calculation, but the essence is that businesses must allocate revenue and expenses between qualifying activities, which are certain production activities that take place in the United States, and nonqualifying activities, such as foreign production activities and other production activities in the United States.

The deduction is 9% of qualified production activity income (QPAI), but is limited to the business’s overall income, and to 50% of wages associated with the production activity. Congress imposed the limitation based on wages to encourage hiring employees to raise the limit and, in turn, the deduction. QPAI is the business’s net income (revenues minus cost of goods sold minus manufacturing expenses) from the qualifying U.S. production activity.

Business Casualty Loss Deduction

Business casualty losses are the result of events beyond the control of the business in which assets are stolen, damaged, or destroyed. The tax effects are handled differently from personal casualty losses, so be careful not to confuse them.

The calculation of a business casualty loss deduction depends on whether the asset is completely destroyed or stolen, or if it’s only partially destroyed. If the asset is damaged but not destroyed or stolen, the amount of the deduction starts with any insurance proceeds received due to the loss. From those proceeds, subtract the lesser of a) the asset’s tax basis, or b) the decline in value of the asset as a result of the casualty. This is the deductible casualty loss when the asset is damaged but not destroyed.

If the asset is destroyed or stolen, the deductible amount is the insurance proceeds, minus the adjusted tax basis of the asset. As a reminder, adjusted basis is the cost of the asset minus total depreciation taken over the life of the asset. Other adjustments are possible, but that is the basic calculation of adjusted basis.

Inventory

Inventory is included in the deduction section because of its relationship to cost of goods sold (COGS), often the largest single business deduction. A business that has substantial inventories must use the accrual method to account for inventory and gross profit, even if the business uses the cash method to account for the rest of its business.

Congress created an exception for businesses that do not sell substantial amounts of goods. This exception allows a cash-method business to use the cash method to calculate inventories and gross profit, if annual gross receipts average no more than $10 million per year for the 3 prior years. So, if a business has gross receipts for the previous 3 years of $8 million, $10 million, and $11 million, the average annual gross receipts are $9.67 million, meaning the business can choose whether to use the cash method or the accrual method to calculate inventory and gross profit.

Congress also created the uniform cost capitalization rules (UNICAP) in an attempt to bring uniformity to the tax calculation of inventory and COGS. The UNICAP rules also delayed the deduction of some costs, raising tax revenues for the government. The UNICAP rules require that costs incurred (inside a production facility, as well as costs incurred outside a production facility in support of production activities) must be capitalized into the valuation of inventory. The deduction of these costs will be delayed until the product is sold. There are exceptions for selling, advertising, and research costs, and for businesses that resell personal property (personalty) and have no more than $10 million in average annual gross receipts for the prior 3 years.

Businesses also must choose an inventory cost flow assumption to calculate the value of inventory and COGS. Please be aware that the choice of cost flow assumption does not have to match the actual physical flow of goods. For example, you may be aware that grocery stores are always rotating their stock to increase the chances of selling older items. That is, older items are moved to the front, and newer items are put toward the back. Since most people pick up the item closest to them, the physical flow of goods is first-in, first-out (FIFO). However, the grocery store can pick another method to account for inventory for tax purposes.

Generally, businesses will choose from first-in, first-out (FIFO), last-in, first-out (LIFO), or specific identification.

• Under the FIFO system, the cost flow assumption is that businesses sell the older items first, leaving newer items in inventory. If costs are rising over time, this assumes, relative to other methods, that lower-cost items are in COGS, and higher-cost items are in inventory.
• Under the LIFO system, the cost flow assumption is that businesses sell newer items first, and older items remain in inventory. This cost flow assumption gives the opposite result from FIFO when costs are rising, since it acts as if the newer, higher-cost items are sold first, putting higher costs into COGS and reducing taxable income. Because of this artificial reduction in taxable income, the tax law now mandates that LIFO can be used for tax purposes, only if it is also used for financial reporting purposes.
• The final option is specific identification, which assumes a business can identify the specific cost of each item sold. At one time, this was a very difficult assumption if the business sold mass-produced items, making it a useful tool only in businesses that produced or sold custom-made products. However, the development of more advanced computer and scanning technologies has made the specific identification cost flow assumption a more realistic possibility than ever before.