Entertaining expenses is an often misunderstood, and over-reported, tax deduction that can lead to unintended IRS scrutiny of a taxpayer’s return. That does not mean that a taxpayer should not take this deduction, but that the taxpayer needs to be aware of the IRS rules regarding these expenses.
The IRS describes entertaining expenses as “ordinary and necessary expenses to entertain a client, customer, or employee”. Ordinary is defined as “common and accepted” in your industry. Necessary is defined as “helpful and appropriate”. Expenses include activities and meals that provide “entertainment, amusement, or recreation.”
In order to meet the IRS’ rule, entertaining expenses must pass one of two tests: the “directly-related test” or the “associate test”. Significantly, you do NOT have to demonstrate that the entertaining expenses resulted in increased revenue or other business benefit.
The “Directly-Related” Test
To pass the directly-related test, one of the following must be true:
- The entertaining took place in a “clear business setting”. This may include free meals or products to customers, entertaining people with whom the taxpayer has no social or personal relationship, or paying for an entertaining event at a trade convention.
- (a) the main purpose of entertainment was “the active conduct of business”; (b) during the entertainment, the taxpayer engaged in business; AND (c) there was “more than a general expectation of getting income or some other specific business benefit.”
Significantly, the following activities are generally not “directly-related” to business: conversations at a nightclub or sporting event, a hunting trip, social gatherings, or a meeting that includes people unrelated to the business.
The “Associated” Test
To pass the associated test, the entertainment must: (1) be associated with your active conduct of business; and (2) come before or after “substantial business discussion.” Associated means that there was a “clear business purpose” for the entertainment, such as generating business or nurturing an existing business relationship. Substantial business discussion is not defined and does not have to meet any amount of time; instead, it is considered on a case-by-case basis. Further, before or after generally means the same day as the substantial business discussion. Entertainment on the same day as meetings at trade shows or conventions would meet the associated test.
As a general rule, entertainment that is extravagant for your business type or industry will draw red flags. You cannot claim an entertainment expense for meals that you have already claimed as a travel expense—this would be double claiming a deduction.
Further, there is a 50% deduction limit for unreimbursed entertainment expenses. The only entertaining expenses that may be fully deducted include: entertaining expenses for the benefit of charity, to provide occasional meals to your employees, to enhance the goodwill of your business, or are “essential” to your business.
Contact an Experienced Tax Attorney
The last thing you want as a small business is an IRS tax audit. However, a quick way to fall into this trap is to file a tax return with inaccurate or improper deductions. If you have concerns about your entertaining expenses and whether they qualify for a tax deduction, you should speak with an experienced tax attorney. Contact the Law Office of Robert S. Thomas for a consultation. I have over twenty years of experience in IRS tax law matters and can give you honest, accurate tax advice. Contact our offices today at 847-392-5893 to schedule a consultation or visit our website today.