Passing the Tests for Entertainment Deductions

If you’re a business owner, you probably entertain customers, prospects, employees, suppliers, and others. Such outlays may be deductible, whereas others are in a gray area. If you know the rules, you can support your deductions and withstand IRS scrutiny.

Direct action

To be deductible, entertainment expenses must pass either the so called “directly related” or “associated” tests. Either way, expenses must be both ordinary and necessary to your business. Typically, activities that are commonly used and helpful in some way will be considered ordinary and necessary. Example 1: Eli Smith, who owns the Smith Co., takes his marketing vice president, Carol Jones, to lunch at a local restaurant to discuss the launch of a new product. Because this lunch takes place in a clear business setting, the cost probably is tax deductible. However, like most entertainment expenses, Smith Co. can deduct only 50% of the total cost. Even if you merely take someone out to lunch, you should be able to show that the main purpose of the outing was related to your business. The IRS says that you must have talked about business matters during the meal, and you must have had a specific business benefit in mind. In order to demonstrate your actions and your intent, in case you’re ever questioned, you should keep some type of log in which you record all the details right after you entertain, including your business purpose. For example, your business purpose could be taking long-term and newly hired employees out to lunch in order to build interpersonal relationships. Note: You don’t have to show a successful result, such as closing a deal, but you need to have a valid business reason for entertaining.

Associated activity

The IRS states that business entertaining in a setting that offers “substantial distractions” won’t meet the directly related test. Such settings include nightclubs, ball games, golf courses, and so on. In those situations, you may qualify for tax deductions if the entertainment is associated with your trade or business. You must have a “substantial business discussion” directly before or after the outing. In order for a business conversation to be substantial, you must be able to show that you were actively engaged with the other party or parties to get a specific business benefit. The business discussion must be substantial, in relation to the entertainment, so a brief request for an order may not justify deducting hundreds of dollars in basketball tickets. As long as the conversation takes place on the same day as the entertainment, the IRS considers it to be held directly before or after the entertainment. Again, you should keep a log to record such activities. What if the entertainment and the business discussion are not held on the same day? A deduction might still be justified, depending on the specific facts and circumstances.

You may have more leeway if you are entertaining people who traveled to meet you.

Example 2: Three top executives from the Collins Co. come in from out of town to discuss a proposed business venture with the Smith Co. They arrive Monday afternoon, and Eli Smith takes all three to a basketball game Monday night. On Tuesday, Eli has a substantial conversation with the visiting executives, going over the proposal. The IRS has said that the game generally may be considered to have taken place directly before the discussion, so the ticket costs can meet the associated test. Here,

Eli probably is on solid ground for deducting 50% of his outlays. Please feel free to contact our office if you have any questions about the deductibility of entertainment expenses.

Copyright AICPA

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