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What Are the IRS Rules for Business Meals and Entertainment Expenses?

The tax rules for deductibility of meals and entertainment expenses have rigorous require-ments, as the distinctions between business and personal expenses can become blurred. Reimbursements to employees for entertainment expenses under accountable and nonaccount-able plans will have different effects on both the employee and employer.

Entertainment covers entertaining guests at nightclubs, theaters and sporting events, and at facilities such as yachts, country clubs and hunting lodges. Meals are considered a form of entertainment. For an expense to be deductible as a meal or entertainment, it must meet the following tests.

Ordinary and necessary business expense

All business expenses must meet the general deductibility requirement of being "ordinary and necessary" in carrying on the business. These terms have been broadly defined to mean customary or usual, and appropriate or helpful. Thus, if it is reasonable in your business to entertain clients or other business people, you should be able to pass this general test.

"Directly related" or "associated with"

A second level of tests applicable to meals and entertainment expenses must be satisfied. Under these tests, the business meal or entertainment expenditure must be either "directly related" or "associated with" the business.

"Directly related" means involving an active discussion aimed at getting immediate revenue. Thus, a specific, concrete business benefit is expected to be derived, not just general goodwill from making a client or associate view you favorably. The principal purpose for the event must be business, and you must have engaged actively during the event, via a meeting, discussion, etc.

The directly related test can also be met if the meal or entertainment takes place in a clear business setting directly furthering your business i.e., where there is no meaningful personal or social relationship between you and the others involved. Meetings or discussions that take place at sporting events, nightclubs or cocktail parties - essentially social events - would not meet this test.

If the "directly related" test cannot be met, the expense may qualify as "associated with" the active conduct of business if the meal or entertainment event precedes or follows (i.e., takes place on the same day as) a substantial and bona fide business discussion.

This test is easier to satisfy. The event is considered associated with the active conduct of the business if its purpose is to get new business or encourage the continuation of a business relationship. "Goodwill" entertainment at shows, sporting events, nightclubs, etc. can qualify. For meals, you or an employee must be present. For example, if you simply cover the cost of a client's meal after a business meeting, but don't join him or her, the expense will not qualify.

Substantiation

The IRS requirement for proving that the expense qualifies is as important as meeting the above tests. Reasonable estimates are not sufficient to stand up to IRS challenge. You must be able to establish the following to properly substantiate the expenditure:

• Amount spent
• Time and place
• Business purpose
• Business relationship of the individuals involved

Keep careful, detailed records of each business meal and entertainment event to justify its business connection.

The account book, diary, log, statement of expense, trip sheet or similar record must be prepared or maintained so the record of each expenditure is made near the time of the expense. An expense account statement submitted to you by an employee in the regular course of business will satisfy this requirement. For expenses of $75 or more, documentary proof, such as a receipt, is required.

Deduction limitation

Other limitations apply when deducting meals and entertainment expenses. Expenses that are "lavish or extravagant" are not deductible. This is generally a "reasonableness" test and does not impose any fixed limitation on the cost of meals or entertainment expenses. As such, expenses incurred at first-class restaurants or clubs can qualify as deductible.

More importantly, once the meal or entertainment expenditure qualifies, it is only 50% deductible. Expenses subject to the 50% limit include not only the direct cost of the business entertainment or meal, but also taxes, tips and related expenses. However, the cost of transportation to and from the location of the business entertainment is not subject to the 50% limitation.

M&E and accountable vs. nonaccountable plans

More often than not, employers will reimburse employees or advance them cash for business-related entertainment expenses. The way in which employers and employees must handle these expenses depends on whether the reimbursement or advance is paid under an accountable or nonaccountable plan.

Under an accountable plan, the employer deducts the amount paid, subject to the 50% limitation; there is no payroll or income tax withholding requirement, as the expense isn't reported as compensation income to the employee. Any expenses not reimbursed by the employer are deductible by the employee, but the 50% limit applies at the employee level and the expenses are miscellaneous, itemized deductions subject to the 2%-of-AGI floor as long as the employee maintains proper records for support.

Any amount treated as paid under a nonaccountable plan is included in the employee's income as wages and is subject to payroll and income tax withholding requirements when paid.

The employee may offset the additional compensation income with business expense deductions (if necessary records and receipts are retained), but the 50% limit applies at the employee level and the expenses are miscellaneous itemized deductions subject to the 2%-of-AGI floor. Thus, the employer is allowed to deduct the full amount paid as compensation.

Entertainment expenses are deductible only if:

• It qualifies as an ordinary and necessary business expense
• It was "directly related" or "associated with" the business
• Proper documentation substantiates the expense
• Only 50% of the expense is deductible. Advances and reimbursements under accountable vs. nonaccountable plans affect both employers and employees differently.

Questions about M&E deductibility or record keeping?
Contact Cara Hoffman at 312-980-3274.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.