Substantiation Requirements for Entertainment Expenses Claimed as Deduction by Employees

March 7, 1978 REVENUE REGULATIONS NO. 03-78 SUBJECT : Substantiation Requirements for Entertainment Expenses Claimed as Deduction by Employees TO : All internal revenue officers and others concerned Pursuant to Section 326 of the National Internal Revenue Code as amended, the following regulations are hereby promulgated to implement further the provisions of Section 30(a)(1) of the National Internal Revenue Code requiring substantiation of entertainment expense deductions. SECTION 1. Requirements for deductibility of entertainment expenses . If an expenditure for entertainment is claimed under Section 30(a)(1) of the Tax Code, the taxpayer must establish that it (a) constitutes ordinary and necessary expenses incurred in carrying on a trade or business, (b) is reasonable in amount and (c) is duly substantiated. SECTION 2. Employee's business expense deductions . (a) If an employee entertains at his own expense a customer of his employer, the entertainment being for the purpose of furthering the business interest of the employer, the basic question concerning the deductibility or nondeductibility of such expense involves a reconciliation of two basic principles, namely: (1) an employee's job is his trade or business and (2) a taxpayer may not deduct the expenses essentially attributable to another's trade or business. If the employee was neither required to make the expenditures nor was he reimbursed by his employer for entertaining persons for the benefit of the employer, the expenses are, if at all, ordinary and necessary expenses of the employer and not such expenses of earning his salary as an employee. This means that while an employees job is truly his trade or business, it is the employer who is expected to define the range of that employee's business. (b) Entertainment, travel and other expenses are deductible from gross income by an employee only to the extent that they are reimbursed and included in gross income. If an employee is not required by his employer to travel or entertain and is not given an allowance or is not reimbursed for expenses incurred in connection with earning his salary or compensation, or for the benefit of his employer, he is not entitled to deduct such expenses from his gross income. aisa dc (c) The nature of the expense allowance or reimbursement given to an employee by his employer determines further whether the employee can deduct expenses paid or incurred out of such allowance or reimbursement which is included in his gross income. For this purpose, expense allowances are classified into nonbusiness expense allowance and business expense allowance . A nonbusiness expense allowance which is intended as an additional compensation for personal services rendered constitutes taxable income which must be reported by the employee in his income tax return. Amounts actually spent by the employee out of these allowances do not constitute deductible items from gross income. Typical of these nonbusiness expense allowances are: living expense allowance, housing allowance, subsistence allowance, etc. (d) Business expense allowances are intended to reimburse the employee for expenses incurred by him for the benefit of his employer or in connection with the performance of his duties as an employee. The method of reimbursing an employee's business expenses determines the tax treatment of such expense allowances. (1) Cash advance type The employer gives the employee a cash advance to cover anticipated expenses in connection with the employer's business. The employee submits an accounting to his employer of the amount actually spent out of the cash advance and any excess of the amount of cash advance given the employee over the amount actually spent is returnable to the employer. (2) Reimbursement by employer of what was actually spent by the employee Under this type, the employee spends first for any business expense in connection with his employment or as required by the trade or business of his employer. He is later reimbursed for said business expense by his employer. (3) Fixed or variable allowance Under this arrangement, the employer recognizes the necessity on the part of the employee to incur expenses for the business of his employer or in connection with the performance of his duties as an employee. The employee is therefore given a fixed or variable allowance for such expenses. With respect to the first and second types of reimbursements, the employee need not report the same in his income tax return either as gross income or as expense deduction, provided that the total amount of reimbursement is equal to such expenses. However, if the reimbursement exceeds the actual expenses and the excess is not returned to the employer the same constitutes taxable income. With respect to the third type of business expense allowance or reimbursement, the same should be reported as part of the employee's gross income. However, the employee upon compliance with the requirements of substantiation, may deduct the amount actually paid or incurred out of such allowance received. SECTION 3. Reasonableness as a limitation . In the audit or verification of income tax returns of employees, the examiner shall, as a rule, limit the deduction for entertainment expenses to 10% only of the gross compensation income, including all types of allowances or reimbursements received from the employer, but in no case shall the amount to be allowed exceed the business expense allowance for entertainment. In all cases, the examiner should see to it that all claims for entertainment expenses must meet the substantiation requirements of the second paragraph of Section 30(a)(1) of the Tax Code as implemented further in this Revenue Regulations. SECTION 4. Effectivity of these regulations . These regulations shall take effect upon approval hereof. CESAR VIRATA Secretary of Finance Recommended by: EFREN I. PLANA Acting Commissioner of Internal Revenue