Entertaining a tax deduction - business entertaining

Nation's Business, March, 1988 by Bill Chastain

Entertaining A Tax Deduction

When it comes to business entertaining, says Ron Layton, sales manager for C.G. Trigg & Son, a food brokerage in Tampa, golf matches and lunches are highly effective.

The results of those activities "are invaluable to our business," he says.

But Layton also emphasizes: "Our clients fully understand our intentions. We're not out to give them a free ride because we love them; it's because we want to get their business."

That no-nonsense approach to the complex--and often controversial-- subject of business entertaining embodies the critical standard for the tax deductibility of such expenses: a direct and demonstrable business purpose.

The deduction has withstood many years of accusations of widespread abuses and demands that it be eliminated. The allegation that the tax laws enable business executives to write off recreational expenses has been a staple of the opposition to the deductibility of business entertainment.

But the view of appropriate entertainment as a legitimate business expense has prevailed, albeit with additional limitations imposed by the 1986 tax-reform act. The most notable is the reduction of the deductible amount from 100 to 80 percent of the cost of business meals. Because of those changes, it is important for business people to be up-to-date on current rules governing business entertaining.

Basically, business entertaining, done countless times in various ways every workday, must meet certain standards and recordkeeping requirements for federal-tax deductibility. A business person who knows the rules and exercises sound judgment can achieve a reliable understanding of the kinds of entertainment expenses that the Internal Revenue Service would decide are legally deductible.

Some people view entertaining--especially when it looks excessive or unnecessary --as a tax-dodging game occasionally played to unethical excess. But for many men and women in business, entertaining is a necessary and useful business tool. The company may come out ahead by acquiring new clients or keeping longtime customers happy, but rarely does it lose as long as the expense is indeed deductible.

Determining what kind of entertainment expense is deductible can be difficult. A key factor is intent, says Bill Ferrell, a partner with the Tampa accounting firm of Darby, Sheahen, Weissman and Morgenstern. "The issue is whether the expenses incurred while entertaining qualify as ordinary and necessary business expenses." Ferrell notes that to claim an entertainment deduction you must have "records to substantiate your entertainment expenses. You can't estimate them. You have to have actual validation, or the IRS could disallow the deduction."

Even those entertainment expenses that are deductible are still subject to limits--the 80 percent rule and the 2 percent requirement.

Only 80 percent of business-related meals and entertainment expenses are tax-deductible. The limit is applied to the person who ultimately paid the bill; if the employee paid initially and was reimbursed by the employer, then the employer can claim 80 percent as a deductible expense. The limit also applies to self-employed persons who incur entertainment expenses.

The 2 percent requirement means a person cannot take a miscellaneous deduction --which includes unreimbursed entertainment expenses as well as other expenses--until the total of such deductions for the year is more than 2 percent of his adjusted gross income.

All business-entertainment expenses must meet the Internal Revenue Service's requirement that they were "directly related to" or "associated with" the conduct of business. Moreover, deductions are not allowed for what the IRS terms "lavish or extravagant" entertainment. The IRS provides no specific standards for determining what would be considered "lavish or extravagant." But it does say that deductions are not disallowed just because the expenses are incurred at ritzy restaurants or because they involve first-class accommodations or services.

In the absence of definitive guidelines, tax advisers suggest that business people are capable of determining reasonable cost levels that would avoid challenge.

Another important consideration is the IRS requirement that an entertainment expense, to be deductible, be incurred in a "clear business setting." Some examples:

A hospitality room at a convention where business goodwill is created through display of or discussion about business products.

Entertainment that has the main effect of a price rebate in the sale of your products, such as occasional free meals furnished to a wholesaler's or a retailer's regular customers.

Clearly business entertaining under circumstances in which there is no meaningful personal or social relationship between you and the persons entertained.

The IRS has defined several places where conducting business or contacting new clients is unlikely. One such place might be a football game, where talking about business could be difficult. Nonetheless, the IRS says you may prove otherwise by showing that you did engage in a substantial business discussion before or after the game.