Meal and Entertainment Deductions
Many business owners entertain: clients, colleagues, potential sources of new business. Networking and building relationships is often critical - and few things help build a relationship like a shared meal or a joint social event.
But those activities can also be expensive and can greatly impact your bottom line - unless you have an effective plan and you know how the tax code works.
The basic rule is you are allowed to deduct the cost of meals or entertainment that have a bona fide business purpose. A bona fide purpose includes meals or entertainment with clients, prospects, referral sources, and business colleagues.
The general rule is you are allowed to deduct 50% of your meals and entertainment as long as it isn't "lavish or extraordinary". Why can you only deduct 50% of the cost? The IRS assumes you would eat, even if you didn't have a business purpose for the meal, so they compromise and meet you halfway on the expense.
Keep in mind that some entertainment expenses qualify for a 100% deduction. If you hold an employee picnic or holiday party, you can deduct the entire expense even if business is not discussed, but only if all employees are allowed to attend.
Employee functions aside, here is how the meals and entertainment deduction works. To qualify, meal and entertainment expenses must:
- Be of a type qualifying as meals or entertainment
- Have a necessary relationship to your business activities
- Be supported by adequate records that substantiate the expenses incurred
Let's look at each category in detail.
• Be of a type qualifying as meals or entertainment. In general, expenses for any activity intended to provide entertainment, amusement, or recreation can qualify. Examples: Entertaining guests at nightclubs or at social or athletic clubs; at theaters; at sporting events; or on hunting, fishing, or hiking trips. If a client is from out of town, providing meals, a hotel, or a car can also be considered an entertainment expense.
Keep in mind tickets to entertainment are usually deductible but only to face value (if you pay a scalper a $100 premium for tickets you can't deduct the additional amount above face value). If you do not attend the event yourself but simply provide the tickets, you can decide whether to consider the tickets a business gift (deductible up to $25 of actual cost) or as entertainment (at 50% of cost).
Entertainment expenses include the cost of meals you provide to customers or clients whether the meal alone is the entertainment or whether it's a part of other entertainment (like hot dogs and beer at a football game). Meal expense includes the cost of food, drinks, tax, and tips.
Finally, you can deduct 50% of meals and entertainment at your place of business, at a separate venue, or even at your home. To do so, they must have a necessary relationship to your business activities. Expenses must be closely related to your business in order to be deductible. In the IRS's view, your expenses may qualify if they meet one of the following two tests:
- Directly Related Test. If the entertainment takes place in a business setting and is designed to directly promote your business, the expense satisfies the Directly Related Test. If you cannot meet the "clear business setting" requirement, the expense must meet all of the following requirements:
- You must have more than a reasonable anticipation of deriving income or a specific business benefit from the meal or entertainment. You don't have to show that income or a specific business benefit was the result of the get-together - just that you had a reasonable expectation there would be a result.
- During the meal or entertainment you actively engage in substantive business discussions.
- The main purpose of the meal and entertainment is to actively conduct business.
With that said, what kinds of expenses tend to not be considered directly related? It can be tough to justify a direct relationship to business if there are substantial distractions like at a concert or the theater, or if you attend a cocktail party, or if the group includes people attending who are not there for business purposes. In other words, the clearer the purpose, setting, and participants, the better.
- Associated With Test. Meals and entertainment expenses may be deductible under the more lenient "Associated With Test" if they meet the following two requirements:
- The expenses are associated with the active conduct of your business.
- The meal or entertainment comes immediately before or directly after a substantial and bona fide business discussion.
Entertainment that occurs on the same day as the business discussion tends to automatically qualify as immediately before or directly after. If the meals or entertainment and the business discussion don't occur on the same day, the situation is analyzed on a case-by-case basis. Mitigating factors can include where you went, what you did, whether you or the other parties are from out of town, and any other reasons the meals or entertainment didn't take place on the same day you had substantial business discussions.
Whether a business discussion is considered to be bona fide depends on the circumstances of each event. If you are challenged you must establish you actively engaged in a business discussion for the purpose of obtaining income or another direct business benefit. Just keep in mind you don't have to prove you spent more time on business than on "pleasure", but you may struggle to justify four days of hotel expenses for one day of discussion.
• Be supported by adequate records that substantiate the expenses incurred. The IRS requires you to keep accurate records showing income, gains, losses, expenses, costs, basically anything that affects your income tax liability, and you have to keep those records for as long as they may be relevant to any subsequent audits or investigations. In general terms, you need to keep all records that support items on your tax return for at least four years since the IRS can challenge your return for up to three years after the filing year.
In order to claim any deduction you need to prove two things: What an expense was for and that the expense was in fact paid for. In other words you can't fake a receipt or invoice. What qualifies: Receipts or invoices with a description of the item/service and its cost, canceled checks, and credit card statements and/or receipts.
If you are audited and do not have records of a certain expense but it seems obvious you must have incurred the expense (like, for instance, you ordered and received business cards but aren't able to find the invoice), the IRS will typically estimate the amount of your expenses. But why estimate - and possibly miss out on deductions - when you can keep accurate records and deduct everything possible?
Certain expenses are subject to special documentation rules mostly because the IRS feels these expenses lend themselves especially to, well, cheating. If you don't have accurate records these expenses are likely to be disallowed:
- Expenses for travel away from home (including meals and lodging)
- Meals and entertainment expenses
- Business gifts
- Automobile and other transportation expenses
- Cell phones, computers, and other items that can be easily used for entertainment or recreation
For anything in the list above you will need receipts for expenses over $75. For lodging you need receipts even if the cost was less than $75.
You must substantiate the expense by showing the amount, the time and place, and the business purpose. Plus for entertainment, meals, and expenses, you must identify the business relationship of the persons involved. An easy way is to simply write names and purpose(s) on all your receipts.
Note: The IRS does not require you to keep a contemporaneous - in other words, completely up to date - record of your expenses. On the other hand, if you save receipts and make notes about time, place, participants, and purpose, your records will be as accurate as possible - and the likelihood is greater the IRS will accept them at face value. Recreated documentation looks and feels recreated, and raises a red flag for an auditor. Plus, if you systematically record your expenses, you can ensure you do not let any items slip through the cracks, allowing you to maximize the use of deductible expenses.
So take a step back. How often do you entertain? Do you ever discuss business? If so, are you deducting the expense of those meals? You can deduct entertainment expenses if they take place directly before or after substantial, bona fide discussion directly related to the active conduct of your business. You can deduct the face value of tickets to sporting and theater events, food and beverages, parking, taxes, and tips.
So act like a reporter - but instead of "who, what, when, where, why, and how" record:
- How much?
- What was the business purpose?
- What was the business relationship of the participants/recipients?
As always contact a tax advisor for tax deductibility information.