Business meals and entertainment expenses require you to jump through
several extra hoops in order for them to qualify as deductible.
Additionally, such expenses are subject to certain limitations.
Nevertheless, if you pay careful attention to the rules outlined below, the
expenses should qualify as deductible.
(1) Ordinary and necessary business expenses. All business
expenses must meet the general deductibility requirement of being “ordinary
and necessary” in carrying on the business. These terms have been fairly
broadly defined to mean customary or usual, and appropriate or helpful.
Thus, if it is reasonable in your business to entertain clients or other
business people you should be able to pass this general test.
(2) “Directly related” or “associated with.” A second level
of tests specially applicable to meals and entertainment expenses must also
be satisfied. Under them, the business meal or entertainment must be either
“directly related to” or “associated with” the business.
“Directly related” means involving an “active” discussion aimed at getting
“immediate” revenue. Thus, a specific, concrete business benefit is expected
to be derived, not just general goodwill from making a client or associate
view you favorably. And the principal purpose for the event must be
business. Also, you must have engaged actively during the event, via a
meeting, discussion, etc.
The directly related test can also be met if the meal or entertainment takes
place in a clear business setting directly furthering your business, i.e.,
where there is no meaningful personal or social relationship between you and
the others involved. Meetings or discussions that take place at sporting
events, night clubs, or cocktail parties—essentially social events—would not
meet this test.
If the “directly related” test cannot be met, the expense may qualify as
“associated with” the active conduct of business if the meal or
entertainment event precedes or follows (i.e., takes place on the same day
as) a substantial and bona fide business discussion.
This test is easier to satisfy. “Goodwill” type of entertainment at shows,
sporting events, night clubs, etc. can qualify. The event will be considered
associated with the active conduct of the business if its purpose is to get
new business or encourage the continuation of a business relationship. For
meals, you (or an employee of yours) must be present. That is, for example,
if you simply cover the cost of a client's meal after a business meeting but
don't join him at it, the expense does not qualify.
(3) Substantiation. Almost as important as qualifying for
the deduction are the requirements for proving that it qualifies. The use of
reasonable estimates is not sufficient to stand up to IRS challenge. You
must be able to establish the amount spent, the time and place, the business
purpose, and the business relationship of the individuals involved.
Obviously, you must set up careful and detailed record-keeping procedures to
keep track of each business meal and entertainment event and to justify its
business connection. For expenses of $75 or more, documentary proof
(receipt, etc.) is required.
(4) Deduction limitations. Several additional limitations
apply. First expenses that are “lavish or extravagant” are not deductible.
This is generally a “reasonableness” test and does not impose any fixed
limits on the cost of meals or entertainment events. Expenses incurred at
first class restaurants or clubs can qualify as deductible.
More importantly, however, once the expenditure qualifies, it is only 50%
deductible. Obviously, this rule severely reduces the tax benefit of
business meals and entertainment. If you spend about $50 a week on
qualifying business meals, or $2,500 for the year, your deduction will only
be $1,250, for tax savings of around $300 to $400.
