Many times I am asked how a taxpayer can deduct meals and entertainment on his/her tax return. While it is certainly much more beneficial for individuals that own sole proprietorships to do so, it can also provide benefits to those individuals that are employees of an organization.
Why does this deduction benefit sole propreitors more than employees?
There are a few reasons why meals and entertainment expenses benefit sole proprietors more than employees. First of all an employee that incurs meals and entertainment expenses unreimbursed by their employer must report these expenses on Schedule A (itemized deductions) as “unreimbursed employee expenses”. These expenses only become deductible once they along with some other allowable expenses exceed 2% of the taxpayer’s Adjusted Gross Income. Therefore the taxpayer must itemize his/her deductions and have enough “other” deductions to exceed 2% of their gross income. Sole proprietors can simply deduct them as a business expense, don’t have to itemize and reduce not only their federal income taxes but their self-employment tax as well.
What are the requirements of this deduction?
The IRS states these expenses are deductible if they are both “ordinary and necessary” and meet either the directly-related or Associated test rules.
The directly-related test states:
- 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.
You must also be able to show that the entertainment took place in a “clear business setting” defined as an environment conducive to a meeting. Examples of a clear business setting would be a restaurant or a hospitality suite. Places typically excluded would include nightclubs, spectator sporting events or theaters. If your entertainment did not take place in a clear business setting, then it may be taken as an Associated expense if it passes the tests.
Please keep in mind that discussions during social gatherings such as a cocktail party or meeting with a group that are not business associates at a cocktail lounge or country club are also excluded from the definition of a clear business setting.
The Associated test states that the entertainment is:
- Associated with the active conduct of your trade or business, and
- Directly before or after a substantial business discussion.
You must be able to show that there is a clear business purpose for incurring the expense. Directly before or after a business discussion generally means on the same day. For example you took your client to a basketball game but had dinner before or after the game and had substantial business discussions.
Lastly, keep in mind in almost all circumstances meals and entertainment are only 50% deductible!
Conclusion
This article gives a very brief summary of how to deduct meals and entertainment expenses. This is a tricky area which is almost always closely reviewed upon audit, therefore I would encourage anyone taking these deductions to contact a tax professional.