Every now and again our clients ask us for details about tax deductions we are all familiar with, but just want to know a little more about. We've found that knowing the "rules" can result in higher deductions, if you account for and document your files appropriately. Higher deductions = Less Tax!
Today, we will address the general guidelines of how to ensure you receive the highest tax deduction allowable by law for what your business spends on meals and entertainment. Meals and entertainment expenses require you to jump through several hoops to qualify as deductible and are subject to limitations. Nevertheless, if you pay careful attention to the rules outlined below, the expenses should qualify as deductible.
“Ordinary and Necessary” Business Expenses
All business expenses must meet the general deductibility requirement of being “ordinary and necessary” in carrying on the business. These terms have been fairly broadly defined to mean customary or usual, and appropriate or helpful. Thus, if it is reasonable in your business to entertain clients and/or other business persons, you should be able to pass this general test.
“Directly Related” or “Associated With” Expenses
A second level of tests specifically applicable to meals and entertainment expenses must also be satisfied. To be deductible, the business meal or entertainment expense must be either “directly related” to or “associated with” your business.
“Directly related” means involving an “active” discussion aimed at getting “immediate” revenue. Thus, a specific and concrete business benefit is expected to be derived, not just general goodwill from making a client or associate view you favorably. The principal purpose for an event must be business. Also, you must have engaged actively in business during the event, via a meeting, discussion, etc.
The directly related test can also be met if the meal or entertainment takes place in a clear business setting directly furthering your business (i.e., where there is no meaningful personal or social relationship between you and the others involved). Meetings or discussions that take place at sporting events, night clubs, or cocktail parties—essentially social events—would not meet this test.
If the “directly related” test cannot be met, the expense may qualify as “associated with” the active conduct of business if the meal or entertainment event proceeds or follows (i.e., takes place on the same day as) a substantial and bona fide business discussion.
This test is easier to satisfy. “Goodwill” type of entertainment at shows, sporting events, night clubs, etc. can qualify. The event will be considered associated with the active conduct of the business if its purpose is to get new business or encourage the continuation of a business relationship. For meals, you (or an employee of yours) must be present. That is, for example, if you simply cover the cost of a client's meal after a business meeting, but don't join him at it, the expense does not qualify.
Almost as important as qualifying for the deduction are the requirements for proving that it qualifies. The use of reasonable estimates is not sufficient to stand up to IRS challenge. You should be able to establish the amount spent, the time and place, the business purpose, and the business relationship of the individuals involved. You must set-up careful and detailed record-keeping procedures to keep track of each business meal and entertainment event and to justify its business connection. For expenses of $75 or more, documentary proof (receipt, etc.) is required. The Tax Warriors recommend that you always write on the back of your receipt who was at a particular meal and generally (or specifically, if applicable) what was discussed.
Several additional limitations apply to meals and entertainment expenses. First, expenses that are “lavish or extravagant” are not deductible. This is generally a “reasonableness” test and does not impose any fixed limits on the cost of meals or entertainment events. Expenses incurred at first- class restaurants or clubs can qualify as deductible.
More importantly, however, once the expenditure qualifies, it is only 50% deductible. Obviously, this rule severely reduces the tax benefit of business meals and entertainment. If you spend about $50 a week on qualifying business meals, or $2,500 for the year, your deduction will only be $1,250, for tax savings of around $300 to $400 assuming top tax rates apply to your particular situation.
Certain Deductions Not Limited
The 50% limit on the deduction for meals and entertainment expenses does not apply to the cost of any of the following examples (note this list is not all inclusive but includes those items which may be applicable to most businesses):
- The IRS has privately ruled that a real estate broker, who provides dinner to prospective purchasers before making a sales presentation, is allowed a full deduction for the cost of the meals. Provided none of the broker's owners or employees receives a dinner (PLR 9414040). This could apply to open house events, etc. that you may hold for special projects, etc.
- Food or beverage expenses that are excludable from the gross income of the recipient under the de minimis fringe benefit rules. The Tax Court rejected IRS's contention that the de minimis fringe benefit exception does not apply to meals provided to employees free of charge. Certain de minimis fringe benefits in the realm of meals and entertainment include: Occasional cocktail parties, group meals or picnics for employees and their guests; Traditional holiday gifts of property (not cash) with a low fair-market value (including a meal); Occasional theater or sporting event tickets; Coffee and doughnuts;Soft drinks;Flowers, fruits, books or similar property provided to employees under special circumstances (for example, illness, family crisis, or outstanding performance).
- All meals furnished to employees on the business premises of an employer are treated as furnished for the convenience of the employer if, without regard to this rule, more than half of the employees to whom these meals are furnished on the employer's premises are furnished these meals for the convenience of the employer. Thus, if these conditions are satisfied, the value of all meals furnished to employees is excludable from the employees' income and fully deductible to the employer.
There can be a slippery slope to manage when deducting what you think are allowable business meals and entertainment expenses. The Tax Warriors at Drucker & Scaccetti are always prepared to help you navigate the tax code to help you with compliance. Have a question? Click "Ask a Tax Warrior" below—we have the answers.