Expenses incurred entertaining customers, clients, and employees are often deductible under 26 U.S.C. § 274. Because the rules are quite detailed and contain a collection of exceptions and specific treatments of specific forms of entertainment, including foreign travel, conventions, and cruises, it is particularly important that taxpayers consult with a reputable lawyer or accountant to insure compliance.
Deductible Entertainment
Entertainment is defined by the IRS as any activity that provides amusement or recreation. Entertainment can also include meals. Expenses related to the entertainment such as taxes, tip, cover charge, parking, or room rental fees also qualify as part of the cost of entertainment. Expenses that cater to the personal needs of a client, such as providing a hotel or transportation can also qualify as entertainment related expenses.
Test for Deductibility
In order for an entertainment expense to be deductible, it must satisfy the following three criteria:
- Ordinary for the trade or business. Entertainment qualifies as ordinary if it is common and accepted in the trade of business of the deducting party.
- Necessary. Entertainment is necessary if it is helpful and appropriate for the taxpayer’s business. An expense that is not required still qualifies as necessary if it furthers the taxpayer’s business interests.
- Business related. Entertainment is sufficiently business related if it satisfies either of two IRS tests. These two tests, known as the “directly-related test” and the “associated test” constitute the primary barrier to the deductibility of entertainment related expenses.
The Directly Related Test
In order to satisfy the directly related test, the taxpayer must demonstrate ALL of the following:
- The primary purpose of the event was to actively conduct business. This does NOT mean that more time must be devoted to business than to entertainment; however the taxpayer is required to demonstrate that the business discussion was more than an incidental, minor, or accidental component of the event.
- That business was actively conducted during the event. If a taxpayer intends to actively conduct business but does not follow through on this intention, the expense is not deductible.
- A general expectation of a specific business benefit as a result of the event. Although the expected benefit does not have to actually result, there must be a reasonable expectation of a specific, tangible benefit as a result of the event.
When the entertainment in question occurs in a setting that is unequivocally related to the taxpayer’s business rather than as part of what could be considered a social gathering, the expense will be deductible under the directly related test regardless of the previous three factors. For example, entertaining clients in a hospitality room at a business convention satisfies the directly related test even if there is not an expectation of a specific benefit whereas a cocktail party at a local lounge must still satisfy each prong of the test.
The Associated Test
The associated test is satisfied if the taxpayer demonstrates that the entertainment is both:
1. Associated with conduct of the taxpayer’s business. This means there is a clear business purpose beyond mere entertainment. Securing new business and maintaining existing business are two common business purposes.
2. Substantial business discussion occurred either directly before or directly after the entertainment. “Substantial” is determined on a case by case basis in related to the length of the entertainment and the size of the business expense. Entertainment on the same day as business discussions are always considered to have occurred directly before or after business discussions. When the entertainment occurs on a different day than the one in which business was conducted, a judgment will be made in light of the facts and circumstances.
Amount of Deductibility
The majority of entertainment expenses are subject to the Internal Revenue Service’s 50% limit, articulated in 26 U.S.C. § 274(n). Under § 274(n), one half of the cost of entertainment is deductible as a business expense. The remaining 50% is not deductible. Under 26 U.S.C. § 264(k)(1), entertainment that is “lavish or extravagant” is explicitly made non-deductible. If entertainment is deemed extravagant, only the non-extravagant portion is deductible.
Non-Deductible Expenses
Certain entertainment expenses are explicitly made non-deductible by 26 U.S.C. § 274(a)(3). Among these expenses are dues and membership fees to business, pleasure, recreation, or other social clubs. This includes but is not limited to country clubs, golf clubs, city clubs, hotel clubs, airlines clubs, dining clubs, athletic clubs, and any similar organization. The expense of using any property owned by the taxpayer for entertainment such as a yacht, swimming pool, or hunting lodge is also explicitly prohibited from deduction.
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