If you are in a business where you have employees out on the road, you probably know the beauty of per diems. First, there is the administrative ease of paying someone a flat rate per day they are on the road and not having to worry about expense receipts. Second, you might view it as a bit of a non-taxable perk to your employees since they get the full per diem tax-free whether or not they spend it all, so they might live frugally on the road and pocket the balance.
But there is more to the story, because there is increased IRS scrutiny in this area. We have recently seen two of our clients (one in construction, the other in professional services) get audited by the IRS on the per diems they paid. Also the IRS has recently released guidance regarding whether a taxpayer is subject to the 50% meals & entertainment deductibility limitation on per diems paid. Let’s explore these risk areas and talk about some strategies.
The 50% Deductibility of Per Diems
It comes as a surprise to some people that they can’t deduct 100% of their per diems paid, since they view this as an unavoidable cost of doing business. Sure, they understand that executives or salespeople can’t wine and dine customers and get a full tax deduction, but these per diems are often being paid to manual laborers who are probably just eating at McDonald’s. But the law is clear that a per diem paid for meals is subject to the same 50% deductibility limit as that fancy dinner with the client. So when you pay a $46 meals & incidental expenses (M&IE) per diem (this is the current Federal CONUS rate for most areas), you will only get to deduct $23 on your tax return. How can you get around this?
Some taxpayers get around this by saying the per diem they are paying is a combined rate for lodging and M&IE. Nothing says you have to pay an employee the full combined government-sanctioned per diem rate (currently $123), so theoretically you could pay $46 and treat it as for lodging and M&IE. Then, you would only treat 40% of the $46 as M&IE, meaning the other 60% is fully deductible (in addition to the 40% being half-deductible). This gets you a tax deduction of $37 instead of the $23 above if the per diem is considered all M&IE. Effectively, a combined per diem is 80% deductible. In order for this strategy to work, you better be able to prove to IRS’ satisfaction that you did not directly pay or reimburse for lodging for the employee, and also that the employee actually incurred lodging costs.
Pigs get fat and hogs get slaughtered, and some taxpayers feel that the ability to deduct 80% of their combined per diem is not good enough. So they want to argue that the per diem they pay is all for lodging and none for M&IE, thus 100% deductible. Well, the IRS is on to that trick and, via legally binding Revenue Procedures, they have prevented this argument from working. The Associated General Contractors of America has been lobbying for a lodging-only per diem for some time but has not had any success. Therefore, this is not currently a viable strategy.
As a side note, the 50% deductibility limit on meals is increased to 80% deductible for workers subject to the Department of Transportation’s “hours of service” limits. This is a different issue than the combined per diem being 80% deductible above. So if you pay per diems to employees subject to these DOT rules, be sure to track those per diems separately.
Recent IRS Developments re: Which Taxpayer is Subject to the Limited Deductibility of M&IE Per Diem
So, if you can’t make the per diem 100% deductible by playing with the lodging vs. M&IE proportions, what other strategies do you have?
One is to treat the per diem as taxable compensation to your employees. This may upset your employees on the surface, but if there is enough of a tax rate differential between your company vs. your employees, then you might be able to make this a win-win situation where the company and the employees both end up with more money in their pockets after tax. This will likely only work in limited situations, and it will be an intensive calculation to arrive at that balance between wages vs. per diem, but it could work. Then your employees would claim the per diem rate as an itemized deduction for employee business expenses on their Form 1040, subject to the 50% limitation for the M&IE portion of the per diem.
Another option a company could use in order to get their per diems paid to be 100% deductible is to pass the deduction limit on to their customers. The IRS recently released guidance on when and how this is permissible. Essentially, as long as the company and its customer agree in writing, and the company bills the customer an amount that is a direct reimbursement of the per diems paid to its employees, then the customer can be the taxpayer subject to the deduction limit on the M&IE portion of the per diem. There are two primary instances where this strategy could work. First, if the customer is a governmental entity or a not-for-profit organization, then they wouldn’t care about the limit on M&IE since they don’t pay taxes anyway. Second, especially for construction contractors, generally what the customer is buying is an asset that will be depreciable over 15 to 39 years, so by passing the limit on to the customer, it would only reduce their depreciation deduction a little bit each year over that time frame. So although the customer would ultimately pay more tax, much of the tax would be paid long in the future (as compared to immediately for the construction contractor), so possibly the contractor and the customer could work out an adjustment to the contract to make this a win-win situation.
As you can see, per diems are not an area where you can just recklessly cut some checks and not worry about the consequences. There are a host of risks and strategies in this area for your company, in addition to possible risks for your employees. If your company pays per diems, or is considering paying per diems, make sure to discuss this area with your accountant.