expenses of entertainment taking place in a hospitality room at a convention, where business goodwill may be generated through the display of business products, or if civic leaders are entertained at the opening of a new hotel or theatrical production, provided that the clear purpose is to obtain business publicity. However, because of distracting circumstances, entertainment is presumed not to have occurred in a clear business setting in the case of a meeting or discussion taking place at a nightclub, theater, or sporting event, or during a cocktail party.

"Associated with" requirement

The second category of deductible entertainment expenditures under the regulations are expenses associated with the taxpayer's business that are incurred directly preceding or following a substantial and bona fide business discussion. This requirement generally permits the deduction of entertainment costs intended to encourage goodwill, provided that the taxpayer establishes a clear business purpose for the expenditure, assuming all generally applicable requirements for business deductions are satisfied.

The "associated with" requirement has not been viewed as requiring that business actually be transacted or discussed during the entertainment, that the discussion and entertainment take place on the same day, that the discussion last for any specified period, or that more time be devoted to business than to entertainment. Thus, if a taxpayer conducts negotiations with a group of business associates and that evening entertains them and their spouses at a restaurant, theater, concert, or sporting event, the entertainment expenses generally are considered deductible as "associated with" the active conduct of the taxpayer's business, even though the purpose of the entertainment is merely to promote goodwill. Entertainment taking place between business sessions or during evening hours at a convention is treated under the regulations as directly preceding or following a business discussion. Entertainment facilities

The section 274 rules were amended by the Revenue Act of 1978 to disallow any deduction (or the investment tax credit) for the cost of entertainment facilities, subject to certain specific statutory exceptions. This general disallowance rule applies to property such as "skyboxes" in sports arenas, tennis courts, bowling alleys, yachts, swimming pools, hunting lodges, fishing camps, and vacation resorts.

Dues or fees paid to a social, athletic, or sporting club are deductible provided that more than half the taxpayer's use of the club is in furtherance of the taxpayer's trade or business and the item was directly related to the active conduct of such trade or business (sec. 274(a)(2)). The expenses of box seats and season tickets to theaters and sporting events have not been disallowed as expenses related to entertainment facilities. Instead, such costs were deductible under prior law if they met the requirements applied to entertainment activities and the general requirements for deducting business expenses.

Exceptions for certain entertainment activities

In general

Prior law included ten statutory exceptions to the general section 274 rules that an entertainment, recreation, or amusement activity expenditure must satisfy either the "directly related" or "associated with" requirement, and that entertainment facility costs are not deductible. If an exception applied, the entertainment expenditure was deductible if it constituted an ordinary and necessary business expense and if any applicable section 274(d) substantiation requirements were satisfied.

The prior-law exceptions were for (1) business meals (discussed below), (2) food and beverages furnished to employees on the taxpayer's business premises, (3) entertainment expenses treated by the employer and employee as compensation to the employee (and so reported on the employer's return and on Form W-2 furnished to the employee), (4) expenses paid by the taxpayer under a reimbursement or other expense allowance arrangement in connection with the performance of services, (5) expenses for recreational, social, or similar facilities or activities for the benefit of employees generally, (6) entertainment expenses directly related to bona fide meetings of a taxpayer's employees, stockholders, or directors, (7) entertainment expenses directly related to and necessary to attendance at a business meeting or convention of a tax-exempt trade association, (8) expenditures for entertainment (or a related facility) made available by the taxpayer to the general public, (9) expenses for entertainment sold by the taxpayer to the public, and (10) expenses includible in the income of persons who are not employees. The regulations under section 274 provide that entertainment expenditures are not deductible to the extent they are lavish or extravagant. Under prior law, the Internal Revenue Service indicated that it would not interpret this provision to disallow deductions merely because entertainment expenses exceed a fixed dollar amount, are incurred at expensive restaurants, hotels, nightclubs, or resorts, or involve first-class accommodations or services (see Rev. Rul. 63-144, 1963-2 C.B. 129).

Meals

Under prior law, expenses for food and beverages were deductible, without regard to the "directly related" or "associated with" requirement generally applicable to entertainment expenses, if the meal or drinks took place in an atmosphere conducive to business discussion. There was no requirement under prior law that business actually be discussed before, during, or after the meal.

Travel expenses

Away from home travel

Traveling expenses incurred by the taxpayer while "away from home" in the conduct of a trade or business (e.g., where the taxpayer travels to another city for business reasons and stays there overnight) generally are deductible if the ordinary and necessary standard for business deductions is met (sec. 162(a)(2)). Personal living expenses such as food and lodging incurred during the trip may be

deductible under this rule. However, travel deductions for amounts expended for meals and lodging are not allowable if such amounts are "lavish and extravagant under the circumstances" (sec. 162(a)(2)). In addition, deductions for any traveling expenses must be substantiated pursuant to section 274(d).

If, while away from home, a taxpayer engages in both business and personal activities, traveling expenses to and from such destination are deductible only if the trip is related primarily to the taxpayer's trade or business. If the trip is primarily personal in nature, the traveling expenses to and from the destination are not deductible; however, any expenses while at the destination that are properly allocable to the taxpayer's trade or business are deductible. The determination of whether a trip is related primarily to the taxpayer's trade or business or is primarily personal in nature depends on the facts and circumstances in each case. An important factor in determining whether the trip is primarily personal is the amount of time during the period of the trip that is spent on personal activities compared to the amount of time spent on activities directly relating to the taxpayer's trade or business (Treas. Reg. sec. 1.162-2(b)).

Deductions for conventions held on cruise ships are limited to $2,000 per taxpayer per year, and are wholly disallowed unless the cruise ship is registered in the United States and stops only at ports of call in this country (including United States possessions) (sec. 274(b)(2)). Also, special rules apply in the case of travel outside the United States that lasts for more than one week (sec. 274(c)).

Traveling costs as deductible education expenses

Traveling expenses may be deductible as business expenses if the travel (1) maintains or improves existing employment skills or is required by the taxpayer's employer or by applicable rules or regulations, and (2) is directly related to the taxpayer's duties in his or her employment or trade or business. Under prior law, some individuals claimed deductions for travel expenses on the ground that the travel itself served educational purposes.

Traveling costs as deductible charitable contributions

A taxpayer may deduct, as charitable donations, unreimbursed out-of-pocket expenses incurred incident to the rendition of services provided by the taxpayer to a charitable organization (Treas. Reg. sec. 1.170A-1(g)). This rule applies to out-of-pocket transportation expenses, and reasonable expenditures for meals and lodging away from home, if necessarily incurred in performing donated services. (No charitable deduction is allowable for the value of the contributed services.) Under prior law, in some instances taxpayers claimed charitable deductions for travel expenses where the travel involved a significant element of personal pleasure, recreation, or vacation. General substantiation requirements

As a general rule, deductions for travel, entertainment, and certain gift expenses are subject to stricter substantiation requirements than most other business deductions (sec. 274(d)). These stricter rules were enacted because the Congress recognized that

"in many instances deductions are obtained by disguising personal expenses as business expenses.'

"348

Under the section 274 rules, the taxpayer must substantiate by adequate records, or sufficient evidence corroborating the taxpayer's statement, (1) the amount of the expense or item subject to section 274(d); (2) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift; (3) the business purpose of the expense or other item; and (4) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift. These substantiation rules apply to: (1) traveling expenses (including meals and lodging while away from home); (2) expenditures with respect to entertainment, amusement, or recreation activities or facilities; and (3) business gifts. In addition, the Tax Reform Act of 1984 (P.L. 98-369) made additional property subject to the section 274(d) rules, including automobiles used for local travel; these additional categories of expense became subject to the section 274(d) substantiation requirements on January 1, 1986.

To meet the adequate records standard, documentary evidence (such as a receipt or paid bill) is required for any expenditure of $25 or more (except certain transportation charges). The Congress has emphasized that no deductions for expenditures subject to substantiation under section 274(d) are allowable pursuant to the Cohan approximation rule. 34b

In general

Reasons for Change

Since the 1960's the Congress has sought to address various aspects of deductions for meals, entertainment, and travel expenses that the Congress and the public have viewed as unfairly benefiting those taxpayers who are able to take advantage of the tax benefit of deductibility. In his 1961 Tax Message, President Kennedy reported that "too many firms and individuals have devised means of deducting too many personal living expenses as business expenses, thereby charging a large part of their cost to the Federal Government." He stated: "This is a matter of national concern, affecting not only our public revenues, our sense of fairness, and our respect for the tax system, but our moral and business practices as well."

After careful review during consideration of the Act, the Congress concluded that these concerns were not addressed adequately by prior law. In general, prior law required some heightened showing of a business purpose for travel and entertainment costs, as well as stricter substantiation requirements than those applying generally to all business deductions; this approach is retained under the Act. However, the prior-law approach failed to address a basic issue inherent in allowing deductions for many travel and entertainment expenditures-the fact that, even if reported accurately and having some connection with the taxpayer's business, such

34 H. Rpt. No. 87-1447, 87th Cong., 2d Sess. (1962), at 19.

34b See, e.g., H. Rept. 99-67, 99th Cong., 1st Sess. 8-9 (1985) (Conference Report on P.L. 99-44).

expenditures also convey substantial personal benefits to the recipients.

The Congress believed that prior law, by not focusing sufficiently on the personal-consumption element of deductible meal and entertainment expenses, unfairly permitted taxpayers who could arrange business settings for personal consumption to receive, in effect, a Federal tax subsidy for such consumption that was not available to other taxpayers. The taxpayers who benefit from deductibility tend to have relatively high incomes, and in some cases the consumption may bear only a loose relationship to business necessity. For example, when executives have dinner at an expensive restaurant following business discussions and then deduct the cost of the meal, the fact that there may be some bona fide business connection does not alter the imbalance between the treatment of those persons, who have effectively transferred a portion of the cost of their meal to the Federal Government, and other individuals, who cannot deduct the cost of their meals.

The significance of this imbalance is heightened by the fact that business travel and entertainment often may be more lavish than comparable activities in a nonbusiness setting. For example, meals at expensive restaurants and the most desirable tickets at sports events and the theatre are purchased to a significant degree by taxpayers who claim business deductions for these expenses. This disparity is highly visible, and has contributed to public perceptions that the tax system under prior law was unfair. Polls indicated that the public identified the full deductibility of normal personal expenses such as meals and entertainment tickets to be one of the most significant elements of disrespect for and dissatisfaction with the tax system.

In light of these considerations, the Act generally reduces to 80 percent the amount of otherwise allowable deductions for business meals, including meals while on a business trip away from home, meals furnished on an employer's premises to its employees, and meal expense at a business luncheon club or a convention, and business entertainment expenses, including sports and theatre tickets and club dues. This reduction rule reflects the fact that all meals and entertainment inherently involve an element of personal living expenses, but still allows an 80-percent deduction where such expenses also have an identifiable business relationship. The Act also tightens the requirements for establishing a bona fide business reason for claiming food and beverage expenses as deductions. The Act includes specified exceptions to the general percentage reduction rule.

In certain respects, more liberal deduction rules were provided under prior law with respect to business meals than other entertainment expenses, both as to the underlying legal requirements for deductibility and as to substantiation requirements. The Congress concluded that more uniform deduction rules should apply; thus, deductions for meals are subject to the same business-connection requirement as applies for deducting other entertainment expenses.