Properly Substantiated Meal and Entertainment Expenses Are Deductible
As a small business owner, you may entertain clients or customers. While this is often a business necessity, the costs can really add up. You'll be glad to know that the IRS allows you to take a deduction for 50 percent of your qualifying business meal entertainment expenses.
What requirements do your meal and entertainment expenses need to meet in order to be deductible? Generally, the answer is that you can deduct ordinary and necessary expenses to entertain a customer or client if:
- Your expenses are of a type that qualifies as meals or entertainment.
- Your expenses bear the necessary relationship to your business activities.
- You keep adequate records and can substantiate the expenses.
What type of expenses qualify as meal and entertainment expenses? Besides meals, expenses for any activity considered to provide entertainment, amusement, or recreation generally fall into this category. Some examples include entertaining guests:
- at nightclubs;
- at social, athletic, and sporting clubs;
- at theaters;
- at sporting events; or
- on hunting, fishing, vacation and similar types of trips.
Meeting personal, living, or family needs of individuals (for example, providing meals, a hotel suite, or a car to business customers or their families) can be an entertainment expense as well.
Entertainment expenses include the cost of meals you provide to customers or clients, whether the meal alone is the entertainment or it's a part of other entertainment (for example, refreshments at a football game). A meal expense includes the cost of food, beverages, taxes, and tips.
You can also deduct 50 percent of business meals or entertainment expenses incurred while:
- entertaining business guests, whether it's at your place of business, a restaurant, or some other place
- attending a business convention, reception, meeting, or luncheon at a club
- traveling away from home on business, whether eating alone or with others on business.
It's important to note that your type of business can determine whether an activity is entertainment, or a fully deductible business expense.
If you're a theater critic who is paid for your reviews, and you attend a theatrical performance in your professional capacity, this is not a 50 percent deductible entertainment expense; instead, it would be a 100 percent deductible business expense.
Similarly, if a clothing designer puts on a fashion show to present his designs to a group of store buyers, it would not be considered entertainment. However, if you are an appliance distributor and you put on a fashion show for your retailers, the show is considered entertainment and only 50 percent would be deductible.
Tickets to entertainment events can be deductible. The cost of entertainment tickets is generally deductible. However, you can only deduct the face value of the ticket even if you paid a higher price (for example, if you pay more than face value for a ticket from a scalper, ticket agency, or ticket broker).
You can, however, deduct the full cost you pay for a ticket, even if it's higher than face value, when the ticket (or a package deal) is to a sporting event that benefits a charitable organization if the event's main purpose is to benefit a qualified charitable organization, the entire net proceeds go to the charity, and the event uses volunteers to perform substantially all the event's work. Also, the 50 percent limitation on entertainment expenses doesn't apply to any expense that is a means of advertising or promoting goodwill in the community.
Every year, Joshua supplies bottles of water and pizza from his restaurant to the participants of a local 5K race to raise funds for cancer research. Joshua can deduct the full cost of the water and pizza because the primary purpose was to promote goodwill in the community.
If you do not attend an entertainment event yourself, you can choose whether to treat the tickets as a business gift (deductible only up to $25) or as entertainment (only 50 percent deductible). You should do the math and choose the option that gives you the largest deduction.
Entertainment expenses for spouses may be deductible. Can you deduct the cost of entertainment for your spouse or a customer or client's spouse? Maybe. You can only deduct these costs if you had a clear business purpose, rather than a personal or social purpose, for providing the entertainment. For example, you would be able to deduct otherwise permissible entertainment expenses of an out-of-town client's husband when it is impracticable to entertain the client for business purposes without him.
It's important to note that you can't deduct the cost of your meal as an entertainment expense if you are claiming the same meal as a travel expense.
Meal, Entertainment Expenses Must Pass Certain Tests
Your expenses for meals and entertainment must be closely related to your business in order to be deductible.
In the IRS's view, your expenses may qualify as "closely related," if they meet at least one of the following two tests:
- the directly related test
- the associated-with test
Even if the expenses are considered related to your business, the sky is not the limit. You can't deduct meal and entertainment expenses to the extent that they are lavish or extravagant. The expenses must be reasonable considering the facts and circumstances.
Setting, Purpose Key To Directly Related Test
If the entertainment takes place in a clear business setting (for example, you provide a hospitality room at a convention) to promote your business, the expense satisfies the directly-related-to test.
If you can't meet the clear business setting requirement, the expense must meet all of the following requirements:
- You must have more than a vague expectation of deriving some income or other specific business benefit (other than a favorable attitude of the person entertained) from the meal or entertainment. However, you don't need to show that income or other business benefit actually resulted from each deducted expenditure.
- During the meal or entertainment, you actively engaged in business discussions.
- The main purpose of the combined business and entertainment is the active conduct of business.
Expenses not considered directly related. The atmosphere of the meeting can have an impact on whether the expense is directly related to your business.
The following situations will create a presumption that the directly related test is not met. The burden then falls on you to prove the IRS is wrong in its presumption.
- There are substantial distractions, such as meetings or discussions at night clubs, theaters, or sporting events;
- The meetings or discussions take place at social gatherings, such as cocktail parties;
- The group includes persons other than business associates, (for example meetings at cocktail lounges, country clubs, golf or athletic clubs, or at vacation resorts).
Associated-with Test May Be Easier To Meet
Meals and entertainment expenses may be deductible under this more lenient test if they meet the following two requirements:
- The expenses are associated with the active conduct of your business. This means that there was a clear business purpose, including getting new business or bolstering an existing business relationship.
- The meal or entertainment directly precedes or follows a substantial and bona fide business discussion.
Timing is crucial factor. Entertainment that occurs on the same day as the business discussion automatically meets the "directly precedes or follows" requirement. If the entertainment and the business discussion don't occur on the same day, the facts and circumstances of each case are considered.
The relevant facts are the place, date, and duration of the business discussion, whether you and your business associate are from out of town (and the dates of arrival and departure), and the reasons the entertainment didn't take place on the same day of the business discussion.
Whether a business discussion (such as a meeting, negotiation, transaction, etc.) is substantial and bona fide depends on the facts and circumstances of each case. If the IRS challenged you on this, you would have to establish that you actively engaged in the business discussion (not the entertainment) for the purpose of obtaining income or some other type of specific business benefit. However, you don't have to show that more time was devoted to business than entertainment.
Business Gifts Are Subject to Limits
Small business owners often give gifts to clients, customers and, even employees, in the course of their business, particularly around the holidays. Although you can deduct the cost of certain gifts as a business expense, there are substantial limitations on what you can deduct.
If an item is excluded from gross income under any other provision, then the rules regarding business gifts do not apply. For example, scholarships are excluded from income under a specific tax law provision; therefore, they are not considered gifts. Similarly, most "gifts" to an employee will be treated as taxable compensation for the employee, which is deductible for your business under the normal rules for employees' pay.
Gift Deduction Limit Is $25 Per Recipient
Your business can deduct a maximum of $25 for business gifts you give to any one person during your tax year. This means that no matter how many of your employees, co-owners, or business partners give a customer a business gift, you tax deduction will be limited to $25 per recipient. Any expense over $25 can not be deducted—it simply comes out of your pocket (or the profits of the business.) For example, if you give a client a $50 dollar watch as a gift, you can only deduct $25.
Husband and wife limited to $25 per couple. For purposes of the business gift expense deduction, if both you and your spouse give gifts, you are treated as one taxpayer. (This is in contrast to many other tax provisions that permit a married couple to double the amount.) Consequently, you and your spouse, together, can claim only $25 per recipient. This is true even if you have separate businesses, are separately employed, or have an independent business connection with the gift recipient.
Direct and Indirect Gifts Are Counted
The $25 limit for business gifts includes both direct and indirect gifts. Figuring out if you gave a direct gift is a pretty straightforward. If you give a fruit basket to each of ABC Corporation's 10 employees, then you made a direct gift to each one of them. Determining whether you made an indirect gift is trickier because, in an audit situation, the IRS will want to know who received the gift, and also who was actually intended to benefit from the gift.
You give your client's live-in relative, Aunt Mabel, a single ticket for a basketball game. Now, at the time you gave her the ticket, you probably had a pretty good idea that she would ultimately give the ticket to your client who is an avid basketball fan. Do you think the IRS will classify this as an indirect gift to your client? You can bet on it.
However, if you have bona fide business dealings with Aunt Mabel--she is a very good customer of your business--and you know that she is also a basketball fan, then the gift would probably not be considered an indirect gift.
Gifts to corporations or businesses. Gifts made to corporations or to business entities which are intended for the personal use or benefit of an individual (such as the president or manager) or a small class of individuals are considered to have been made to the individual or individuals who actually benefit from the gifts.
However, if the gift is not intended for the eventual personal use or benefit of a particular individual or a limited class of individuals, and it is not practical for you to determine who actually used the gift, the gift will not be considered to be made to an individual and the $25 limit will not apply. On the other hand, the 50 percent limit on deductible entertainment expenses may apply if the gift could be considered entertainment (such as a gift of tickets to a sporting event).
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Food gifts are subject to the dollar limit. What about food-related gifts? Should you treat their cost as a meal expense or a gift expense? There is a special exception in the tax rules that says, if you give a customer or client packaged food or beverages that you intend them to use at a later date, you should treat the cost as a gift expense, not a meal expense.
Incidental Costs Are Not Counted
The $25 limit for business gifts doesn't include incidental costs. Related costs are considered incidental only if they don't add some kind of substantial value to a gift. Examples of incidental costs are packaging, insurance, and mailing costs, gift-wrapping, or the cost of engraving jewelry.
Page sends his business clients a fruit basket every year at the holiday season. The fruit basket for the higher-value clients is packaged in a lacquered wooden basket that can be reused after the fruit is gone. On the other hand, the "basket" for lower-value clients is simply a cardboard trap with a cellophane covering,
If the lacquered wooden basket has a substantial value compared to the value of the fruit; therefore, the cost of the basket is not incidental and it must be included in the $25 limit. However, the cardboard packaging is incidental and doesn't have to be included in the $25 limit.
Dollar Limit Does Not Apply to Low-Cost Items
Promotional items, such as key chains or pens with your business name on them, that you distribute to customers or clients are generally not considered gifts. Therefore, they are not subject $25 limit for business gifts, provided they fit into one of these categories:
- items that
- cost $4 or less,
- have your name clearly and permanently imprinted on them, and
- are one of a number of identical items you widely distribute
- signs, display racks, or other promotional material to be used on the business premises of the recipient
Special Rules Apply to Entertainment Gifts
What happens if you give tickets to a play or sporting event to a customer or client? Is this a gift expense or an entertainment expense? The general rule is that any item that could be considered either a gift or an entertainment expense must be considered an entertainment expense.
If you go with the client, you must treat the cost of the tickets as an entertainment expense - you have no choice. However, if you give the tickets and do not attend the event yourself, you have the choice of determining whether an item is either a gift or entertainment expense.
Taking into account the $25 limit for gifts and the 50 percent limitation on entertainment expenses, it's generally better to treat a ticket expense as entertainment when it is over $50.
For example, you gave a client ballet tickets that cost $140. If you deduct them as a gift expense, your deduction is limited to $25. However, if you deduct them as an entertainment expense, your deduction is $70. Conversely, if you gave a client tickets to a movie premiere that cost $30, you would get a bigger deduction by claiming a gift expense ($25 as opposed to $15 for an entertainment expense).