NOTE: Since the passing of the New Tax Law in 2017, the rules for deducting the expenses mentioned in this article have changed. Please visit our newest blog on these changes and their impact on deductions. Click here to read our new blog.
The IRS has plenty of rules regarding deducting expenses from business income; one area that has plenty of rules is entertainment. As business owners and managers, we have options when it comes to spending money for encouraging and promoting new sales and customers. And buying meals or taking clients to events is a great way to form a relationship with new and existing clients. But Meals & Entertainment Expense is also one place the IRS will certainly look if your company is ever selected for an audit. Let’s look at some of the details of entertainment expenses and explore what is allowed by the IRS.
What makes entertainment deductible? To qualify as a tax deduction, the main purpose of the entertainment must be to conduct business with a reasonable expectation of obtaining a specific business benefit from the event. That means that inviting a customer out to dinner where the discussion revolves around what vacations, family, and sports is not a deductible entertainment expense. Whereas an active discussion of business plans, contracts, or strategy would quality for an entertainment deduction. There is no mention of the length of the business discussion; it is not necessary that you spend more time on business than on entertainment.
Be careful if considering a business fishing, hunting, or weekend golf trip. The IRS generally does not think that business is the main purpose when combined with some other clearly non-business activity. An exception is made for team-building or retreat type events such as a manager trip to the beach for strategic planning (with some incidental fishing) or a golf day as a reward for hitting certain goals within an organization. One note regarding rewards, they may be considered compensation and while deductible to the business, could be taxable to the employee. Also, any expense that is lavish or extravagant under the circumstances is not going to be allowed. Please consult your tax advisor for more details on these topics.
Another point to remember: meals & entertainment expenses are only 50% deductible. One exception to this rule is if the general public is invited to an event– in this case it is classified as advertising expense and would be 100% deductible. We encourage all of our clients to clearly define what constitutes entertainment vs marketing in their accounting procedures.
Another exception is providing lunches to staff while conducting training is 100% deductible since it benefits the entire workforce, offered at the business location, and is a convenience to the greater business objective (training of employees; think Lunch & Learn)
One of the most important things to remember when considering an expense as a business deduction is documentation. Keep adequate records to prove the business purpose, the amount, date, place of the entertainment, and the business relationship of the persons entertained. There is no requirement to show that a business benefit really resulted from the entertainment expense, but this clearly will help the argument. Even the IRS would have a hard time arguing that a couple rounds of golf or lunches prior to making a big sale or landing that big client wasn’t a good investment.
All of the facts of the deduction must be considered in order to make the determination of whether the expense is deductible as entertainment. Keep copies of invitations sent out for a product demos, a company anniversary party or other communication that states there will be entertainment. Trying to re-create substantiation of an expense a year or more after it occurred can be very difficult, although this is one area where hindsight may be helpful. Likewise, repeated expenditures with a small group of folks (friends being called “prospects”) can have the opposite effect. Keep this balancing act in mind when considering what information should be required on employee’s expense reports.
For more information on this topic, please visit the website IRS.gov and do a search on business entertainment expenses. We recommend Publication 463 (Travel, Entertainment, Gift, and Car Expenses) for more details about entertainment expense deductibility, ask us for guidance on your specific situation, or contact your tax professional.