There are so many rules governing tax deductions, but the area riddled the most with rules is entertainment. And the IRS loves to audit this line item on a business tax return. An IRS auditor, while suppressing a chuckle, will ask you a few simple questions knowing full well you may not know the rules. Next thing you know, your entertainment deductions have been blown out of the water—so pay attention, here’s what works and what doesn’t when it comes to deducting entertainment costs.
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First of all, entertainment expense is only 50% deductible. Most tax software or your tax pro will ask you for the total spent on entertainment, so don’t split the amount in half. Give the grand total and the software or tax pro will do the rest.
An exception to the 50% rule is if you are inviting the general public to an event you put on to promote your business. In this case, it would be considered advertising expense and as such would be 100% deductible. Naturally, if your business is the business of entertaining, the deduction is also considered an ordinary and necessary business expense, and is not subject to the 50% cut. For example, if you own a bar and hire a band to entertain your customers, the cost is 100% deductible.
To be deductible, the main reason for the entertainment expense would be the active conduct of business. You must be attempting to make a sale or otherwise be conducting business with the specific expectation of getting some business benefit out of the deal. If you are merely having a casual lunch with your tax pro talking sports, kids and fashion trends, then you don’t have a bona fide deduction. Also nix the idea of being able to write off a cocktail party where customers, potential customers and business associates mingle primarily for the purpose of establishing and maintaining goodwill. It won’t fly with the IRS. Now if you were to have a product demo or a speech about the service you provide prior to opening the wine and serving the appetizers, then you will be able to take an entertainment deduction.
The IRS does not believe that business can be discussed on hunting or fishing trips or while aboard a yacht or any other pleasure boat. So don’t bother setting up that kind of entertainment because even if you can demonstrate a valid business purpose, the deduction will not sail.
Nor do they think you can discuss business in a disco setting, at a cocktail party, or during a ball game. However, you are allowed to have a business meeting associated with that kind of entertainment. If you meet with a potential customer and demo your product and give him your sales pitch then take him drinking and dancing or out to a ball game, you have a legitimate write off.
The IRS does not take time into account: As long as you have a substantial business discussion, it doesn’t have to be longer than the entertainment provided.
The IRS also requires that entertainment cannot be “lavish and extravagant.” This is a fairly subjective term, and I imagine what your small business would consider lavish and extravagant might differ just a bit from Donald Trump’s views. So keep the bills down if you don’t want to raise some eyebrows. You risk losing the entire deduction if the IRS doesn’t consider the expenses a reasonable amount.
If you have lunch once a week with a client or business associate and you take turns picking up the check, you likely will not have a deduction. Remember, there must be a substantial business discussion with the expectation of making a sale in order to qualify the entertainment expense.
Entertaining your employees is 100% deductible. So if you have an office party for your employees, you are allowed to write off the entire expense. If however, it’s a mixed party, say with 10 employees, 10 clients and 10 family members for a cost of $300 then you are allowed to write off 100% of the cost attributable to the employees share ($100), 50% of the cost attributable to the clients share ($50) and nothing for the family members share for a total write off of $150.
The same rule governs employee meals. If you provide meals for employees for your own convenience – say it’s tax season and you want your employees to stay in the office for lunch so you order in a pizza – then you have a 100% write off.
Expenses less than $75 don’t require receipts, just make sure you have all the info written down – time, place, who, etc. With that said, it’s easier to just keep the receipt.
Be very careful about writing off dues to certain clubs: country clubs, golf and athletic clubs, airline clubs, hotel clubs are not deductible.
Entertainment facilities such as timeshares, cabins, yachts, swimming pools, etc. are also not deductible business entertainment expenses. There is a case of a business owner audited by the IRS who was disallowed the pro rata share of mortgage interest, property taxes, depreciation and other expenses for the business use of a cabin he owns. Even though he maintained logs demonstrating business use and had allocated the expenses accordingly, the IRS did not allow him to write it off because the cabin was considered an entertainment facility.
One of the most important things to remember is substantiation. Picture yourself in front of an auditor trying to validate a deduction. Do you have a copy of the invite to your party that states there will be a product demonstration prior to the festivities? Do you have the name of the person(s) entertained listed on the receipt? Do you have the trade show flyers listing the associated entertainment? If you entertain people in your home, be sure to keep more than the grocery store receipt. An auditor will simply roll his eyes as he proclaims “disallowed.” So be sure to keep a copy of the invitation that contains a line item mentioning the business purpose. Keep all of these things in your tax file in the event of an audit.
For more information on this topic, of which, I highlighted only the most common rules, please refer to IRS Publication 463.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitterat BLTaxpertise and at Facebook.