Often CPAs get the question from business clients about what they can deduct for meals and entertainment expense. This type of expense requires you to jump through several extra hoops to qualify as deductible and is subject to limitations. Nevertheless, if you pay careful attention to 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. 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.” 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.
- If the “directly related” test can't 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. 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.
(3) Substantiation. Almost as important as qualifying for the deduction are the requirements for proving that it qualifies. The use of reasonable estimates isn't 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 (receipts, etc.) is required.
(4) Deduction limitations. Several additional limitations apply. First, expenses that are “lavish or extravagant” aren't deductible. This is generally a “reasonableness” test and doesn't impose any fixed limits on the cost of meals or entertainment events. Meals or entertainment expenses for spouses or related persons who are present are not deductible, unless that person is an employee or owner of the business.
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 $2,500 a year on meals and entertainment expense, your deduction will only be $1,250.
In certain situations, meals and entertainment expenses can be 100% deductible, so please be sure to discuss with your tax advisor on deductibility. If you have any questions, please feel free to contact our office.