Meal and Entertainment Expenses - The Rules

Larry Villano, Publisher of Loopholelewy.com

As a general rule, when you wine and dine customers, clients, business associates or potential customers or clients, you may only deduct 50% of meal and entertainment expenses. This is true whether you use the actual expense method or the IRS standard meal allowance and whether you're a business owner or an employee. However, transportation costs to and from a restaurant or entertainment facility are 100% deductible

If you simply take a break from working to go out to eat lunch or dinner in the general area of your business, this is a personal expense and is not deductible. If you go out with your buddies and talk about work, that won't qualify for the deduction either.

There's been a lot of abuse in this area so the IRS keeps a watchful eye on meal and entertainment deductions. Audit proof your deduction by keeping a written record that documents your expenses. I'll explain what information you need later in this article.

The Rules

To be deductible, meal and entertainment expenses must be ordinary and necessary to your business and not lavish or extravagant (use common sense here). In addition, they must meet one of two tests:

  1. The Directly-Related Test
  2. The Associated Test

If the directly-related test is not met, you may still qualify for a deduction if the associated test is met.

The directly-related test can be met in one of three ways:

  1. Under the generally related test
  2. As expenses incurred in a clear business setting
  3. As expenses incurred for services performed

The Generally Related Test:

You don't have to prove that income or some other business benefit occurred. You must be able to show a business motive for the dining or entertainment. You must be able to prove that any of the following occurred:

  • a business meeting
  • a business negotiation
  • or a business decision

Devoting more time to business than to entertainment is not necessary. If no business was discussed, be able to show that you would have discussed business but did not because of reasons beyond your control.

Expenses Incurred in a Clear Business Setting:

The people being entertained in a clear business setting are usually people with whom you have no personal or social relationship. This could involve giving a free dinner to a customer who regularly attends your hotel for example.

Expenses Incurred for Services Performed:

You will also meet the directly related test if you entertain people with whom you have no personal or social relationship and the entertainment is done in a clear business setting. For example, you have a grand opening and invite a few civic leaders in your community to attend in order to get publicity.

When the Directly-related Test Will Not Be Met

The directly-related test for the meal and entertainment deduction generally will not be met if any of the following apply:

  • You are not present during the entertainment
  • The distractions are substantial. For example, at a night club or sporting event where the noise level may be too high to allow for a business discussion.
  • You meet with a group at a cocktail lounge, country club, athletic club, or vacation resort.

If you entertain clients or customers on hunting or fishing trips or on a yacht, you must be able to prove that there was a business purpose.

The Associated Test:

If you cannot meet the directly related test, you may still qualify for the meals and entertainment deduction by meeting the associated test.

Under the associated test you must be able to show that directly before or after the dining or entertainment a substantial and bona fide business discussion occurred related to the active conduct of your business.

As a general rule, the IRS says dining and entertainment should occur on the same day. If this was not possible, be prepared to explain why. For example, if an out-of-town customer arrives at your business late in the day, you may entertain the customer that evening, then discuss business the next day. This would be an acceptable reason for not complying with the general rule.

Goodwill Entertaining:

The associated test can apply to goodwill entertaining. Under this test you can entertain in a nonbusiness setting, like a nightclub, restaurant, theater, or sports arena. For example, during the day you conduct substantial business discussions with business associates. Later that evening you take your associates and their spouses and your spouse to dinner and a play.

In this case, because your business associates brought their spouses to participate in dining and entertainment, you may bring your spouse as well and deduct the meal and entertainment expenses for yourself, your spouse, and your associates and their spouses.

Meals and beverages, including the tax and tip, are only 50% deductible. You may deduct 50% of the face value of the theater tickets. You may not deduct 50% of a higher value that you may have paid. For example, if the tickets were hard to get and you paid a scalper $100 for each ticket but the face value of the tickets was $50 each, you may only deduct $25 per ticket (50% x $50).

Transportation expenses to and from the restaurant and theater are 100% deductible.

Exceptions to the 50% Limitation Rule:

If meal and entertainment expenses fit any of the following exceptions, they are 100% deductible:

  • Recreational and social activities for employees including, the company Christmas party, company picnic, occasional meals, such as a pizza party, the Thanksgiving turkey or ham you give to employees.
  • Promotional activities, for example, the cost of food and beverages provided to members of the general public who agree to sit through your sales presentation.
  • Tax-free de minimis fringe benefit such as, expenses of providing an employee cafeteria on the employer's premises and more than 50% of the employees to whom meals are provided are furnished the meals for the employer's convenience.
  • Meals and entertainment you pay for employees if the cost is included in the employees compensation subject to income tax withholding.
  • If you own a restaurant and provide meals to employees from your restaurant, you include the cost in your cost of goods sold and not in the employee's compensation.

Department of Transportation Workers

Workers who are subject to the Department of Transportation's "hours of service" limits can deduct 80% of their meal expenses. This applies to air transportation workers under Federal Aviation Administration regulations, truck operators and bus drivers under Department of Transportation regulations, railroad employees under Federal Railroad Administration regulations, and merchant mariners under Coast Guard regulations.

Where to Deduct Meal and Entertainment Expenses:

Self-employed Individuals deduct 50% of the cost of meals and entertainment on Schedule C, Line 24 (b). Employees report unreimbursed business expenses on Form 2106 or 2106-EZ. The deduction is carried to Schedule A as a miscellaneous itemized deduction where it is subject to the 2% of adjusted gross income floor. Self-employed individuals are not subject to the 2% floor because they claim the deduction on Schedule C.

Audit Proof Your Deduction

Make sure you document the following 6 items to support your meal and entertainment expenses:

  1. Date
  2. Amount (including taxes and tip)
  3. Place
  4. Business purpose
  5. Name of business associate(s)
  6. Relationship of individual(s) such as, customer, client, potential customer, employee.

A good habit to get into is making notes on the back of receipts, in a business diary, or in a calendar.

You could jot down something like... "01/15/2014, lunch with Jack Jones, customer; Figaro's restaurant; $75; discussed new line of widgets. This information is needed even if you use the IRS standard meal allowance.

So go ahead and enjoy yourself while you're building your business. Uncle Sam is standing by to pick up part of the tab!

File your personal and small business taxes (Schedule C)