Meals and entertainment can be a sizable chunk of a company’s budget – but can also help reduce tax liability
My favorite client, Joe, is in sales. He is finally getting a chance to use his box seats for the Cleveland Cavaliers to take a client to see the championship game. He called me up to ask what, if any, of the evening’s expenses he could deduct on the company’s tax return. When I asked how business is going, he mentioned his sales team has been performing so well this year he’s taking his top five salesmen and their families on a cruise. I surprised him when I told him not only will much of the cost of the game be deductible, but even that cruise might benefit his bottom line on his tax return.
As a general rule, taxpayers can deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on their trade or business – including expenses incurred wining and dining clients and rewarding non-highly compensated employees. These expenses can be significant for many taxpayers, and this often-overlooked source of deductions is worth investigating to significantly reduce overall tax liability.
The statutory scheme for meals and entertainment
To be deductible, the meals and entertainment (M&E) expense must be:
- an ordinary and necessary business expense,
- “directly related” or “associated with” the conduct of business, and
- substantiated by sufficient documentation.
Even if the expense is otherwise deductible, however, two additional limitations are imposed. First, the expense cannot be considered “lavish or extravagant.” Second, the total amount of the deduction is limited to 50 percent of the amount spent, unless the expense falls within an enumerated exception to this 50 percent limit.
What is “lavish or extravagant”?
The “lavish or extravagant” limitation leaves it open to IRS interpretation whether the expense is unreasonable. You can look at “lavish or extravagant” as “not ordinary and necessary.” Deductions are not disallowed simply by virtue of their amount or because the expense was incurred at a high-end restaurant or nightclub. Some of these types of expenses may not be lavish or extravagant under the circumstances. In Joe’s case, the cruise might seem lavish at first blush, but the IRS may actually allow the deduction depending upon its accounting treatment. If your client is a high-net-worth individual, a dinner at the most expensive restaurant in town is likely not extravagant.
On the other hand, circumstances may make an expense “extravagant” when you would not otherwise think so. The box seats for the Cavaliers game are excessive per the IRS, and the deductible amount would be limited to the cost of the highest non-box seat in the arena.
Getting around the 50 percent limitation
Once the hurdles to deductibility have been cleared, taxpayers should (but too often don’t) look to see whether they can avoid the 50 percent limitation on the deduction. Commonly invoked exceptions include M&E treated as compensation to the employee receiving them, expenses incurred in providing de minimis fringe benefits, recreational expenses for employees, items available to the public, and entertainment sold to customers. For example, portions of the cruise expense might be deductible if, subject to certain limitations, the cost of sending the employee on the cruise can be deducted if the company treats the cost to be wages to the employee.
The IRS regulations contain many other examples of expenses that are not subject to the 50 percent limitation. Among them are expenses incurred in holding company functions such as Christmas parties and small team-building events; costs incurred in maintaining recreational facilities such as a pool or golf club available to all employees; costs of promotional incentives given to the general public, such as wines provided to a wine store’s customers at a tasting; and meals provided to potential customers such as a real estate firm’s catering at a sales presentation. Taxpayers in the M&E business, such as restaurants, are not limited by the 50 percent deduction when the meals and entertainment are sold to customers. A restaurant may deduct the full cost of the food it purchases to serve, for instance.
Pitfalls to avoid
Failing to analyze the 50 percent limitation: Don’t take the M&E deduction without going through the analysis to determine if the 50 percent limitation applies. Over-application of the limit unnecessarily increases tax liability, but under-application of the limit opens the taxpayer to penalties.
Failing to maintain adequate substantiation: The IRS sets a high standard for the documentation required for M&E expenses. Often a taxpayer will know the amounts spent on meals and entertainment with sufficient certainty to prepare the tax return, but if audited, the documentation must stand up to IRS scrutiny. Failure to meet the substantiation requirements will render the deduction disallowed, opening the taxpayer to penalties. For example, regulations require that for any expense over $75, the taxpayer maintain records of:
- The amount and description of each individual expenditure
- The time and place it was incurred
- The business purpose of the activity (including the benefit expected from the activity and the nature of any business discussion occurring at the activity)
- The business relationship of the individuals entertained.
Unacceptably lavish or extravagant expenses: As noted above, “lavish or extravagant” is subject to IRS interpretation. A taxpayer will have to employ common sense – if the extravagance seems out of proportion to the nature of the business, the taxpayer should carefully weigh the reasonableness of the deduction.
It’s worth it
M&E expenses can take up a significant chunk of a company’s budget. While the substantiation requirement may seem administratively burdensome, in truth it can be overcome through a recordkeeping process that makes it routine to keep the required information. It is worth the trouble, as the deduction can have a significant positive impact on tax liability.