Most business owners deduct expenses for entertaining clients, customers, or employees. Have you ever wondered what the letter of the law is when it comes to these deductions? Below are the requirements that you should consider when taking and documenting an entertainment deduction:
You can deduct entertainment expenses only if they are both ORDINARY AND NECESSARY AND meet ONE of the following tests:
• Directly-related test
• Associated test
An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be required to be considered necessary.
Directly-Related Test
To meet the directly-related test for entertainment expenses you must show that:
• The main purpose of the combined business and entertainment was the active conduct of business,
• You did engage in business with the person during the entertainment period, and
• You had more than a general expectation of getting income or some other specific business benefit at some future time.
It is not necessary to devote more time to business than to entertainment. However, if the business discussion is only incidental to the entertainment, the entertainment expenses do not meet the directly-related test. You do not have to show that business income or other business benefit actually resulted from each entertainment expense.
Clear business setting - If the entertainment takes place in a clear business setting and is for your business or work, the expenses are considered directly related to your business or work. The following situations are examples of entertainment in a clear business setting:
• Entertainment in a hospitality room at a convention where business goodwill is created through the display or discussion of business products.
• Entertainment that is mainly a price rebate on the sale of your products (such as a restaurant owner providing an occasional free meal to a loyal customer).
• Entertainment of a clear business nature occurring under circumstances where there is no meaningful personal or social relationship between you and the persons entertained. An example is entertainment of business and civic leaders at the opening of a new hotel or play when the purpose is to get business publicity rather than to create or maintain the goodwill of the persons entertained.
Expenses not considered directly related - Entertainment expenses generally are not considered directly related if you are not present or in situations where there are substantial distractions that generally prevent you from actively conducting business. The following are examples of situations where there are substantial distractions:
• A meeting or discussion at a nightclub, theater, or sporting event.
• A meeting or discussion during what is essentially a social gathering, such as a cocktail party.
• A meeting with a group that includes persons who are not business associates at places such as cocktail lounges, country clubs, golf clubs, athletic clubs, or vacation resorts.
Associated Test
Even if your expenses do not meet the directly-related test, they may meet the associated test.
To meet the associated test for entertainment expenses, you must show that the entertainment is:
• Associated with the active conduct of your trade or business, and
• Directly before or after a substantial business discussion.
Associated with trade or business - Generally, an expense is associated with the active conduct of your trade or business if you can show that you had a clear business purpose for having the expense. The purpose may be to get new business or to encourage the continuation of an existing business relationship.
Substantial business discussion - Whether a business discussion is substantial depends on the facts of each case. A business discussion will not be considered substantial unless you can show that you actively engaged in the discussion, meeting, negotiation, or other business transaction to get income or some other specific business benefit.
The meeting does not have to be for any specified length of time, but you must show that the business discussion was substantial in relation to the meal or entertainment. It is not necessary that you devote more time to business than to entertainment. You do not have to discuss business during the meal or entertainment.
Meetings at conventions - You are considered to have a substantial business discussion if you attend meetings at a convention or similar event, or at a trade or business meeting sponsored and conducted by a business or professional organization. However, your reason for attending the convention or meeting must be to further your trade or business. The organization that sponsors the convention or meeting must schedule a program of business activities that is the main activity of the convention or meeting.
Directly before or after business discussion - If the entertainment is held on the same day as the business discussion, it is considered to be held directly before or after the business discussion.
50% Limit - In general, you can deduct only 50% of your business-related meal and entertainment expenses. The 50% limit applies to employees or their employers, and to self-employed persons.
The 50% limit applies to business meals or entertainment expenses you have while:
• Traveling away from home (whether eating alone or with others) on business,
• Entertaining customers at your place of business, a restaurant, or other location, or
• Attending a business convention or reception, business meeting, or business luncheon at a club.
What Entertainment Expenses Are Deductible?
Entertainment - Entertainment includes any activity generally considered to provide entertainment, amusement, or recreation. Examples include entertaining guests at nightclubs; at social, athletic, and sporting clubs; at theaters; at sporting events; on yachts; or on hunting, fishing, vacation, and similar trips.
Entertainment also may include meeting personal, living, or family needs of individuals, such as providing meals, a hotel suite, or a car to customers or their families.
A meal as a form of entertainment - Entertainment includes the cost of a meal you provide to a customer or client, whether the meal is a part of other entertainment or by itself. A meal expense includes the cost of food, beverages, taxes, and tips for the meal. To deduct an entertainment-related meal, you or your employee must be present when the food or beverages are provided.
Trade association meetings - You can deduct entertainment expenses that are directly related to and necessary for attending business meetings or conventions of certain exempt organizations if the expenses of your attendance are related to your active trade or business. These organizations include business leagues, chambers of commerce, real estate boards, trade associations, and professional associations.
Entertainment tickets - Generally, you cannot deduct more than the face value of an entertainment ticket, even if you paid a higher price. For example, you cannot deduct service fees you pay to ticket agencies or brokers or any amount over the face value of the tickets you pay to scalpers.
What Entertainment Expenses Are Not Deductible?
Club dues and membership fees - You cannot deduct dues (including initiation fees) for membership in any club organized for:
• Business,
• Pleasure,
• Recreation, or
• Other social purpose.
You cannot deduct dues paid to:
• Country clubs,
• Golf and athletic clubs,
• Airline clubs,
• Hotel clubs, and
• Clubs operated to provide meals under circumstances generally considered to be conducive to business discussions
The IRS does pay attention to meals and entertainment expenses so it is important for taxpayers to understand the rules regarding what is deductible and what is not and also to maintain adequate records of the cost and business purpose of all meals and entertainment expenses.
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