All work and no play isn’t good for you, or your business. Even the IRS recognizes that entertainment has a place in a business, but there are limits to how much fun they will let you write off as business expenses, rules for what you can write off and regulations for how to record it so you can deduct it on your taxes.
Tax law limits most of your deductions for entertainment expenses to 50% of the original expense. In order to qualify as a deduction, all business entertainment must meet six elements of substantiation. It makes no difference what other types of support you have for your business entertainment; failure to meet the six elements will result in dis-allowance.
Substantiation Requirements for All Business Entertainment Expenses
The entertainment must be incurred in the “ordinary and necessary” course of your business and then documented to meet IRS substantiation requirements. Failure to meet the requirements will cause a loss of valid deductions.
- Cost: The cost of each entertainment expenditure must be recorded someplace. When the cost is $75 or more, documentary evidence such as a receipt, voucher, or credit card charge copy must be retained to support expenditures. No receipts are required for entertainment expenses under $75 per expense.
- Time: The definition of time is usually the date when the entertainment takes place. When entries are made in a diary-type document, the date on the diary page is adequate support for time.
- Description: The nature and place of the entertainment (“business meal at The Dirty Nail”) must be described. When a charge slip or receipt is obtained, the nature and place are usually self-evident.
- Business purpose: Of the six elements, this is the most important. A specific advanced purpose for the entertainment is required. You must have a specific business purpose to meet with your prospect in order to deduct any entertainment with them. The following examples will illustrate this:
Example: Bill goes to a local steakhouse alone for dinner. He strikes up a conversation with the waitress about his real estate business. His dinner would not be deductible since he didn’t have a prearranged appointment to meet with her.
Example: Bill is talking with his next door neighbor, Sally. She mentions that she is considering selling her house but doesn’t have time to talk about it at that moment. Instead she suggests that Bill come to the restaurant where she works for lunch as a waitress and talk about listing her home over lunch. This meal would be deductible.
- Business relationship: The IRS wants you to identify the person or persons entertained. The names, occupations, official titles, and other corroborative information to establish the business relationship should be identified. In many cases, the person’s name with the word “prospect” would be sufficient to establish both business purpose and business relationship for a business meal.
- Timely Recording: The recording must be contemporaneous with the activity. For all practical purposes, that means you must record the elements of substantiation on a timely basis, preferably on the day the entertainment takes place.
TIP: Discuss business when you eat.
Deducting Business Meals
Applying the substantiation rules to a business meal means the following are required in order to deduct it.
- You must discuss business before, during, or after a business meal to qualify for a business meal deduction.
- The business meal must be arranged for the purpose of conducting specific business before the fact.
- The business meal must take place in surroundings conducive to a business discussion. IRS presumes that the “active business discussion” test is not met if the business meal occurs under circumstances where there is little or no possibility of engaging in a business discussion. Eating dinner at a nightclub with a continuous floorshow is an example of a non-business setting. Similarly, a large cocktail party is not a business setting.
Documentation of a Business Meal: Answering the questions “Who?”, “Where?”, “When?” and “Why?” and recording the cost as shown will give you proper documentation for business meals.
|Where?||The 5th Gear Restaurant|
|When?||May 20th, 2012|
|Why?||Arrange for Endorsement of Product|
|Valet & Coats||
Deducting Associated Entertainment Expenses
According to tax law, you may not discuss business in places and at events that are not business settings. Examples of non-business settings include, but are not limited to:
- Golf courses
- Sports events
- Hunting trips
- Fishing trips
- Ski trips
By themselves, entertainment expenses for activities like those above are not deductible. However, they can be deducted under the “associated entertainment” rule. Associated entertainment, also called goodwill entertainment, takes place in a non-business setting. No business discussion occurs during the entertainment. The entertainment precedes or follows a substantial and bona fide business discussion, usually the same day as
the entertainment. The key to deducting associated entertainment is linking it to a related business discussion and recording the link. There must be a link between the business discussion and the entertainment.
Documentation of a Business Meal Followed by a Theater Performance
Note how the theater event is linked to the meal with the word Followed. Also note that the business discussion occurred in a proper business setting and was followed by entertainment “associated” with the dinner discussion.
|Where?||Zephyr’s & Bankhead|
|When?||May 20th, 2012|
|Why?||Arrange for Endorsement of Product at Dinner Followed by Theater|
Season Tickets to Events: Season tickets and box seats to theaters and sports events are treated according to the individual events. For example, you hold season theater tickets to attend 10 specific performances during the year. You treat each of the 10 performances separately. The deduction is limited to the printed face value of the ticket.
Business Gifts: Tax law limits your maximum deduction to $25 for business gifts to any one person during a tax year. This limitation applies to gifts of tangible personal property. Husband and wife are treated as one taxpayer for purposes of the $25 limit. However, gifts made to business where there is no single person designated to receive or benefit from the gift, have no limit. There is an alternate rule for gifts of entertainment tickets. You have the choice of treating the gift of a theater ticket either as entertainment or as a business gift. There’s no $25 limit on the entertainment gift. Moreover, when giving tickets as gifts, you need not go along to the entertainment event.
Meals are not entertainment: Gifts of entertainment meals are not allowed. You are entitled to a tax deduction for a business meal only if you are present during the consumption process.
Feed and entertain your spouse: The IRS has a “closely connected” rule. Most spouses qualify as closely connected. The closely connected rule permits deducting the expenses of entertaining your spouse as well as the spouse of a business guest. In other words, if your business guest brings a spouse, you are entitled to bring yours. Of course, you must be entertaining the business guest during the ordinary and necessary course of your business and you must meet the business discussion and documentation requirements.
Deducting Dutch-treat Meals
When you go to a meal with a business guest, pay your own way and spend more than what you would normally spend, the Dutch-treat rule comes into play. For example, you attend a Chamber of Commerce luncheon meeting and the lunch costs more than you would normally spend for lunch; you may claim the excess as a Dutch-treat business lunch.
Example: You spend $22 at a Chamber luncheon. Had you not gone to the luncheon, you would have spent $2. Your deduction is $10, the excess business cost over your personal cost (times 50%).
The “Sutter Rule”
IRS may, at its discretion, invoke the “Sutter Rule”. The “Sutter Rule” allows IRS to disallow a portion of your business meals when such meals absorb substantial amounts of your typical living expenses.
Document personal meal costs to support your Dutch-treat meals and avoid the “Suffer Rule.”
- Written evidence: Your personal meal evidence must be in writing. Entries in your diary or account book are strong evidence.
- 30-Day test: Record the cost of personal meals in your diary. Do this for at least 30 days during the year.
- Meals at home: When you eat meals at home, the task of developing your personal meal costs is somewhat more complicated. There are basically two ways to compute the cost of personal meals consumed at home.
Method 1: Write down the actual items consumed and determine the cost of each item. Two eggs for breakfast, when a dozen eggs cost $1.20, would cost $0.20. If you need to determine actual costs only a few times during the year, it’s easy to simply write down the actual items consumed.
Method 2 Use actual grocery bills to make an allocation by members of the family. If, for example, the grocery bill for a week amounts to $150, you can estimate the cost for breakfast, lunch, and dinner. If the dinner groceries cost $70, you could divide the $70 by seven days in a week to arrive at $10 for the average dinner. If there are two people in your family, the average cost per person is $5. That would be your cost for purposes of determining your Dutch-treat deductions and maximum disallowance under the Sutter Rule.
Deducting Home Entertainment
Your home is already a setting conducive to a business discussion. If you invite a couple to your home for dinner, it’s easy to have a one-on-one business conversation. You do not need to spend more time trying to conduct business than you spend entertaining your guest.
Example: You invite the Jones to your home to ask for a referral. You ask for and receive the referral. Even though 90% of the evening is spent on non-business activities, the cost is deductible. If you asked for and failed to get a referral, the cost of entertainment is still deductible.
Your home entertainment deductions are secure when you discuss specific business with your guests. Keep your guest list small; fewer than 12 people. That way you can talk to everyone with whom you need to discuss business.
When you invite more than 12 people to your home, you will be hard pressed to prove to IRS that you had specific business discussions with everyone in attendance. Therefore, you must establish some other type of commercial motivation.
If you entertain a group for the purpose of showing a display of your business products or services, commercial motivation is generally clearly established. When you combine the display of products with an invitation that invites the guests for a specific business reason, you strengthen your case for deductibility.
Example: Tex built his own office building and is looking for tenants. He throws a party for friends that would be desirable tenants. This party would qualify as a deductible business entertainment expense if it meets both of two tests:
- Clear showing of commercial motivation.
Tex’s invitation established the introduction of the new office building as the reason for the party. In the room where the party was held, Tex had photographs of the new building posted on a bulletin board. Although none of the individuals attending the party rented space in the new building, Tex clearly established a clear business motivation for the party.
- Meet five elements of substantiation.
- Cost: Tex has receipts and cancelled checks.
- Time: Date at top of diary page.
- Description: Entry in diary.
- Business purpose: Entry in diary plus invitations and photographs of people around the bulletin board.
- Business relationships: Names of individuals who own their own businesses and are prospective tenants.
The expenses are deductible because Tex passes both tests.
Personal Celebrations: Never, never combine a personal event with a business entertainment event. A birthday party for your 10-year-old with business guests in attendance will not fly with IRS. Home entertainment, especially when large groups are involved, is deductible only when you can firmly establish a business purpose. If you have no personal or social relationships with the guests, other than business, your chances for a deduction are improved.
Deducting Employee Meals and Entertainment
You may deduct the costs to provide lunches to employees on a tax-free basis if you provide lunch for over one-half of the employees, and
- there is a short lunch period (generally no more than 45 minutes) or
- they are available for emergencies (such as an ambulance service) or
- there are insufficient eating facilities nearby.
Also, meals must be furnished on normal business days.
The reasonable cost of a year-end holiday party or a summer outing for employees and their families is 100% deductible.
Business Club Dues and Lunches: You can deduct dues paid to business clubs when such payment is in the ordinary and necessary course of business. The terms “ordinary” and “necessary” mean that the expenses are customary, usual or normal, and helpful or appropriate. Dues to your local Chamber of Commerce would almost always be appropriate and normal. Dues paid to professional societies are deductible. Trade association dues are deductible if the association’s purpose is the furthering of the business interests of its members. Dues for community clubs organized to attract tourists and new members to your locality give rise to deductible dues.
Note: Meals incurred and “paid for” while talking business at the club are deductible. This limitation only applies to the dues.
Give sales seminars and presentations at home: The tax court has ruled that all food and refreshments served to prospects are 100% deductible if provided at home during a sales seminar or sales presentation.
Business Expense vs. Business Promotion: IRS uses an objective test to determine whether an activity is of a type to constitute entertainment (which is 50% deductible) or more like business promotion (which is 100% deductible). Thus, attending a movie or theatrical performance would normally be considered entertainment. However, it would be deemed promotional, if done so by professional theater critics or movie critics. Similarly, a golf club salesman who plays golf and demonstrates his clubs and other golfing equipment should be able to deduct 100% of his green fees and costs of his golf balls, caddie expense, etc.
Business Entertainment Summary
- Discuss business when you eat.
- Link “associated entertainment” expenses to a business meal.
- Treat season tickets on an individual event basis.
- Use entertainment tickets as business gifts to avoid $25 ceiling.
- Feed and entertain your spouse.
- Deduct Dutch-treat meals.
- By sure to document personal meal costs to support your Dutch-treat meals and avoid the “Sutter Rule.”
- Deduct home entertainment.
- Give small parties at home.
- Properly set up and document large group entertainment to solidify deductions.
- Entertain and feed your employees.
- Deduct business club dues and lunches.
- Give sales seminars and presentations at home.
- Deduct all food at sales presentations.