Business isn’t always about the dull stuff. In fact, entertainment is a part and parcel of most businesses, and the good news is that most entertainment expenses are actually deductible.
In every business, pleasing customers is a must. Especially if you are in sales or marketing, the entertaining customer is an essential part of your job or business. Entertainment expenses are usually paired with meal expenses, and both of them are commonly considered legitimate business expenses.
While it is good to know that there’s a clear rule on entertainment deductions, the problem with many business owners is that they think that just about any theater pass, event or meal with a client or a potential client may already qualify as a valid deduction when in fact, it is not always the case.
But how will you know if your entertainment expenses count as a business?
When Do Entertainment Expenses Count as Pleasure or Business?
Before we get down to the actual rules, let’s try to understand them the easy way. The rules involve figures and stipulations which may sound a bit off for you, but essentially, their bottom line is simply this: When it comes to entertainment expenses, it is usually not considered a deductible expense if you are having too much pleasure. Take a look at these easy-to-understand rules:
- Make business your priority. Always get down to business. Remember that any form of entertainment that you do must in one way or another be related to the conduct of your business, or must at least be associated with a discussion pertaining to your business. Simply put, if we have dinner together but don’t discuss business stuff such as sales projections or tax strategies, and instead talk about our children and family life, then you are not supposed to expect the amount we spend for our meal as a deductible entertainment expense.
The same thing goes for throwing parties. You cannot simply rationalize that you throw a party to build camaraderie with your clients. For the party costs to be deductible, you should be able to conduct business at any time in the course of the party. It can either be before, after or during the party and may include product demonstration or a brief talk.
Aside from soirees, here are other forms of entertainment expenses that you should consider:
- If you are a business owner, meals for your employees during a busy time are entirely deductible. It is better if you track such costs under a separate category such as “crew meals,” so your tax professional will not apply the 50% rule during tax time.
- Do not deduct repeated meals with your business partner when you take turns in paying.
- You can write off your hotel expenses when attending a trade show, but you cannot do it all year round and mark it as an entertainment expense again and again. So, do not try to write off the amount you spend on entertainment facilities, including property taxes, mortgage interest, swimming pool rentals, tennis courts or vacation in a resort.
- You also cannot write off dues that you pay to athletic clubs or hotel clubs, including those that offer free meals when you take part in business discussions.
- Make sure that the environment is conducive for the conduct of business. Before writing off your entertainment expenses after dining somewhere, you have to make sure that the environment is business-conducive enough to qualify for a deduction. There was an instance before when the IRS had to reject the deduction of passes to a baseball game because the noise at the ballpark obviously did not allow for a good business discussion.
- Mind your guest list. In writing off your entertainment expenses, you must also take your guest list into consideration. If your event is organized for employees and their spouses or is open to the general public, you may write off its total cost. On the other hand, if the event is for your clients or potential clients, or those business associates or contractors who conduct business with you, then you are allowed to write off only 50% of the total cost. In case your guest list consists of employees and their spouses and some clients, then part of your entertainment cost may be allocated as a 100% write-off, while the remainder can be a 50% write-off based on the number of guests who attended in every category.
- Do not be too lavish or extravagant. Going overboard is a big no-no for the Internal Revenue Service (IRS). If you want to increases the chances of your entertainment expenses to be written off, always choose to keep your entertainment or meal simple by making sure that its cost is aligned with the budget of your company. That means that if your company is not that big to pay for lavish parties, then do not bring your clients to first-class accommodations or parties and expect the cost to be written off.
- Document everything. If you want to win your fight against the IRS, then you have to build up your defenses. There are cases when people from the IRS would come knocking on doors to ask you to back up your claims for deductions. In the event that they come knocking onto your door, you have to make sure that you are prepared to defend your deductions. You do that by making sure that you keep every little piece of evidence that you can keep to support your deduction claims, such as the invitation that makes clear your business purpose, photos of your guests during a product presentation, or a video clip. You may also want your guests to sign a guest book so you can prove to the IRS the right allocation of your entertainment expenses between company employees, business associates, clients, etc. Most importantly, keep all your receipts. Based on the IRS rule, however, expenses that cost less than $75 do not necessarily require receipts. In such cases, the simple journal entry in your appointment book that includes the names of attendees, the amount spent and the location is enough.
So, when are entertainment expenses deductible?
Basically, entertainment expenses that can be written off are those used to entertain clients or potential clients, customers, business partners, employees, and if these expenses are proven to be–
- “ordinary and necessary” and
- either directly related or associated.
As per the IRS rules on entertainment expenses, it is a must that the expenses are ordinary and necessary before they can be written off. That means that they should be common, accepted and appropriate for the business. Entertainment expenses can be considered necessary even without being required. Also, they should be able to meet at least one of these tests:
- Direct Test. This test involves proving or showing that there was a business purpose to the entertainment and that its main objective was to gain profit. You also must be able to show that it was held in a business setting and that it involved a discussion of the business. If for instance, you gathered your employees somewhere to present employee awards, the amount spent for that event can be considered as a deductible expense. However, if you only went fishing with them and there was no clear connection between the activity and your business, that cannot be considered as a deductible expense.
- Associated Test. In this test, you must be able to show that the entertainment was tied to your business and happened directly before or after a business-related discussion. An example of this would be having a business discussion with your clients in the office and then inviting them to a game after your meeting. That will pass the associated test since it happened directly after the business discussion. However, if you took the clients' days later, then that will not pass this test.
The following are examples of expenses that are not subject to the 50% limit, which means that they are fully deductible:
- Those spent on events that promote goodwill to the community.
- Those spent on events whose proceeds go straight to a charitable organization, provided that the charitable organization is IRS certified.
- Those spent on meals or entertainment that is essential to the business.
- Those spent on meals of employees at the convenience of the employer or for an occasional event.
Entertainment Expenses vs Advertising & Promotion Expenses
In case the nature of your business involves entertaining the general public to advertise or promote, your entertainment cost can be entirely written off as a business expense. If you own a children’s clothing store and you hire a clown to entertain at a community event, that is considered more of a promotion than entertainment.
So how do you write off your entertainment expenses?
As mentioned, you should be able to pass either the direct or associated test and prove your business purpose before you can deduct your business entertainment expenses. Aside from the purpose of your business, you should also be able to prove the following:
- The amount of each expense
- The date/time and location of the entertainment, and
- Your relationship with the persons you entertained (are they your employees, business associates, clients, etc.?)
What if you fail to present a proof?
In that case, the IRS will not be able to consider it as a deductible expense and take it off your tax return. This is where record-keeping comes in.
When it comes to business expenses, you should be meticulous enough to keep all the necessary records to prove that your entertainment expenses can pass either the direct test or the associated test. The IRS usually finds contemporaneous records best. These records should be able to specify the business purpose of the entertainment event. A simple note stating your purpose will suffice. For instance, you can note on the bill from your caterer that the amount paid was used for the annual holiday party of your company.
How much of your entertainment expenses are deductible?
In most cases, only 50% of business-related entertainment expenses are deductible. Depending on whether the entertainment expenses are reimbursed, this 50% limit is applicable to employees or their employers, as well as to self-employed individuals or their clients. The limit particularly applies to the expenses you have while–
- Traveling away from home for business.
- Entertaining clients at a place conducive for business.
- Attending a business conference or meeting.
If you attend an event not related to your business while traveling for business, the amount you spend for that entertainment will not be deductible. The same rule applies if you attend an entertainment event while looking for a possible business location or while investigating a business. The entertainment expense, in that case, is not deductible since you haven’t started the business yet.
Remember also that any lavish or extravagant entertainment in any form is not deductible. Say you want to entertain your clients by buying a yacht, the IRS will not allow you to write off the amount you spent on buying that yacht simply because that is too extravagant.
What if you are self-employed and is therefore neither an employee nor an employer?
Based on the IRS law, entertainment expenses of self-employed individuals are not subject to the 50% limit if all of the conditions below are met:
- The entertainment expenses are tied to your job as an independent contractor
- You are provided an allowance or are reimbursed for the entertainment expenses related to the work that you perform, and
- You are able to show enough proof or records of such expenses for your client or customer.
In every business, treating clients or employees for a meal or entertainment is a great way to build your business, and since it is a legitimate part of the business, it is subject to tax deductions. Knowing which of your entertainment expenses are fully deductible, not deductible or subject to the 50% limit is a must if you don’t wish to deal with troubles with the IRS.