Tax time is coming up and inevitably there are questions we get each and every year from small business owners and employees about what they can and cannot deduct. Of course, it’s probably best to consult a CPA that matches your style of being conservative, middle of the road, or aggressive, but I thought I would give you some direction on several of the questions we get over and over again during tax time. Here is the ‘your smart money moves’ post on deducting your meals and entertainment expenses.
Let’s face the facts. Most small business owners are downright lousy when it comes to keeping high quality records of their meals and entertainment expenses. All they do know is that they would like to deduct every trip to Starbuck’s, every lunch they had at Taco Mac, and every dinner they ate on their last vacation. But the question really is where does the line start and where does the line end when it comes to deducting meals and entertainment expenses.
You may be able to deduct the business related meals and entertainment expenses related to entertaining a client, an employee, or a prospective customer. The IRS has two general rules they lay out for taxpayers to see if your meals and entertainment expenses pass the ‘smell’ test.
- THE DIRECTLY RELATED TEST
- THE ASSOCIATED TEST
As I get into these guidelines, I want you to consider this for a moment. One of the key parts to the smell tests is whether or not this kind of expense is common and accepted in your business or trade. It doesn’t necessarily have to be a required expense, but one that would appear to be normal within the constraints of what you do in a particular industry.
THE DIRECTLY RELATED TEST (source: irs.gov)
To meet the directly-related test for entertainment expenses (including entertainment-related meals), you must show that:
- The main purpose of the combined business and entertainment was the active conduct of business
- You did engage in business with the person during the entertainment period AND
- You had more than a general expectation of getting income or some other specific business benefit at some future time.
The really cool thing about the ‘grayness’ of the definition is that it is NOT necessarily true that you have to discuss more business than you do having entertainment. It just needs to be true that the business isn’t incidental while enjoying the entertainment. Well, how in the world do you figure that one out? The key here is documentation? A well-documented meals and entertainment expense backlog can take you a long way if you are questioned down the road. Do you have a receipt? Did you list the parties involved that you were doing business with that day? Do you have a time, date, and location? Did you discuss what business was potentially being transacted that day? All of these will help your cause down the road.
THE ASSOCIATED TEST (source: irs.gov)
- Entertainment is associated with your trade or business, and
- Entertainment is directly before or after a substantial business discussion.
Generally, an expense can be associated if you can show that it had a clear business purpose for having the expense. An example, may be that you were trying to encourage the continuation of an existing business relationship. It’s important to note here that the more ‘substantial’ the business discussion, the better of a chance you will have to write off the expense. This is why documenting the nature of the meeting and what was discussed makes this more iron clad down the road. However, I have yet to see a situation where the IRS goes back to call a particular prospect or client from many prior years before to see if in fact you had a dinner with them. I’m sure this can happen and has happened, but I have yet to see it in my career.
There are three other rules you should be aware of as you tabulate your numbers for the current tax year. (source: irs.gov)
- You cannot deduct the cost of your meal as an entertainment expense if you are claiming the meal as a travel expense.
- You cannot deduct expenses that are lavish or extravagant under the circumstances. Extravagant would be something like renting out a yacht if you’re normally don’t use yachts in your business.
- You generally can deduct only 50% of your unreimbursed entertainment expenses (see 50% Limit ).
Meals and entertainment expenses are one of the most common questions I get each and every year from prospect and client during tax time. It’s important you sit down and really assess this closely because you may have legitimate expenses you could take to lower your tax liability, but you aren’t writing them off because you don’t’ understand the rules. No TIP for me on this one please (LOL- pun was intended!) and make sure you get your documentation in order come tax time!
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Ted Jenkin is a frequent guest columnist for the Wall Street Journal and Headline News Weekend Express. He is the co-CEO of oXYGen Financial. You can follow him on LinkedIn @ www.linkedin.com/in/theceoadvisor or on Twitter @tedjenkin. >
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