7th-Inning Tax Stretch: Entertainment Expenses That Make the Cut
This Sunday at Nationals Park, amidst the excitement and cheers for the home team, I found myself explaining entertainment deductions to a friend over the seventh-inning stretch. While the Tax Cuts and Jobs Act of 2017 significantly changed the deductibility of entertainment expenses, my scorecard shows there are still ways business owners can turn a day at the ballpark into a tax-saving opportunity. Let’s break down the tax deduction rules of entertainment expenses.
Rules for client entertainment deductions are not as simple as a home run.
The Tax Cuts and Jobs Act (TCJA), enacted in 2017, significantly altered the deductibility of entertainment expenses for businesses. Effective January 1, 2018, common forms of directly related and associated entertainment that are no longer deductible include expenses incurred for golf, football games, and similar business-building activities with clients or prospects.
But certain exceptions survived the curtailment of entertainment expense deductions under TCJA. Let’s review the rules to make the best out of summer outings with clients, employees, and business associates.
What are the requirements for deductibility?
Despite the general non-deductibility rule for entertainment, the tax code Section 274(e) provides specific exceptions. Under this section, businesses can continue to deduct:
entertainment, amusement, and recreation expenses a business treats as compensation to employees and that are included as wages for income tax withholding purposes;
expenses for recreational, social, or similar activities (including facilities therefor) primarily for the benefit of employees (other than employees who are highly compensated employees);
expenses that are directly related to business meetings of employees, stockholders, agents, or directors (here, the law limits expenses for food and beverages to 50 percent);
expenses directly related and necessary to attendance at a business meeting or convention such as those held by business leagues, chambers of commerce, real estate boards, and boards of trade (here, the law also limits expenses for food and beverages to 50 percent);
expenses for goods, services, and facilities you or a business makes available to the general public;
expenses for entertainment goods, services, and facilities that a business sells to customers; and
expenses paid on behalf of nonemployees that are includible in the gross income of a recipient of the entertainment, amusement, or recreation as compensation for services rendered or as a prize or award.
Tax strategies businesses could consider
With the exceptions discussed above, businesses could consider the following to optimize tax deductibility:
Renting a taxpayer’s residence to corporate functions such as business meetings, staff retreats, or employee events (summer picnics, etc).
In considering this strategy, make sure there is a business purpose (“ordinary and necessary”) other than pure entertainment. Document that business activities took place - consider taking photos and making social media posts on them. A fair rental value should be used for the deduction as the IRS has taken the position that an S corporation cannot deduct a rental payment to one of its shareholder more than the residence’s fair rental value - as shown in Roy v. Comm’r T.C. Memo 1998-125.
Also note that, if it’s the rental of one’s residence, the tax code has a special tax exemption for the rental income on that residence if the rental was less than 15 days during the calendar year. This is known as the “Augusta rule” which is under Internal Revenue Code 280A(g). The property does not need to be a principal residence. As long as it meets other deductibility requirements, the business can claim a deduction for the rental expense, while the property owner does not need to recognize income on the rental receipts when total rental days were less than 15 days a year.
Taking employees on an employee party trip.
Tax law allows deductions when the business provides entertainment and entertainment facilities that primarily benefit rank-and-file employees - again, as long as the expenses satisfy other deductibility requirements and are adequately documented.
Partying with employees.
Tax law allows recreational expenses for employees such as holiday parties or summer picnics - 100% - however, be mindful that there is additional scrutiny when determining whether the expenses were personal or business-related if such expenses involve the business owner and the owner’s family members.
Making the owner’s vacation home a deductible entertainment facility.
Extra caution is needed when claiming a deduction for the expenses incurred to use a business owner’s vacation property for business purposes, as any expenses tainted with “entertainment” will be disallowed. However, deduction is allowed when properly structured to meet the exceptions under the tax code.
In Ireland v. Comm’r, 89 T. C. 978 (1987), Court noted that the presence of family members, without direct business reasons, suggested the property was used for entertainment, rendering the related expenses disallowed for deduction. In Ireland, the taxpayer was a stockbroker who used his 3-acre beachfront vacation property for business meetings with investment advisors, clients and other partners of his firm. However, family members of the business associates occasionally accompanied them. While Court noted that the business meetings held in the property would not constitute entertainment, the ultimate ruling was that the presence of family members tainted the business use (no matter how small) and made the property use nondeductible entertainment use. So, careful planning, tax-deductible use and proper documentation of such use is the key when claiming a deduction for using the owner’s vacation property for business.
Creating an employee entertainment facility.
Expenditure for recreational, social, or similar activity primarily to benefit employees is allowed 100% as it is specifically excepted from the disallowance rule for entertainment expenses. The catch is that the expenses must be primarily for the benefit of employees of the taxpayer other than officers, shareholders, or other highly compensated employees.
Deducting the entertainment facility, because the facility use creates compensation to users.
Businesses can deduct any part of the entertainment expenses that were included in taxable compensation to the users/employees as wages to the employee which would be subject to payroll taxes and withholdings.
Meeting the Ordinary and Necessary Standard
The IRS further explains what can be treated as tax-deductible “ordinary and necessary” expenses to entertain a client, customer, or employee if the expense meets the directly-related test or the associated test.
Directly-Related Test
Business is generally not considered to be the main purpose when business and entertainment are combined on hunting or fishing trips, or on yachts or other pleasure boats. It is not necessary to devote more time to business than to entertainment. However, if the business discussion is only incidental to the entertainment, it is not directly related.
If the entertainment takes place in a clear business setting and is for your business or work, the expenses are considered directly related. The following situations are examples of entertainment in a clear business setting:
• Business meal with a supplier at a local restaurant;
• Entertainment at a convention where business goodwill is created through the display or discussion of business products; or
• Entertainment of business and civic leaders at the opening of a new hotel or play when the purpose is to get business publicity rather than to create or maintain the goodwill of the persons entertained.
Expenses generally are not considered directly related when entertainment occurs where, because of substantial distractions, there is little or no possibility of engaging in the active conduct of business. Examples are:
• A meeting or discussion at a nightclub, theater, or sporting event;
• A meeting or discussion during what is essentially a social gathering, such as a cocktail party; or
• A meeting with a group that includes persons who are not business associates at places such as cocktail lounges, country clubs, golf clubs, athletic clubs, or vacation resorts.
Associated Test
Even if your expenses do not meet the directly-related test, they may meet the associated test. To meet this test, you must show that the entertainment:
• Has a clear business purpose. The purpose may be to get new business or to encourage the continuation of an existing business relationship.
• Directly precedes or follows a substantial business discussion.
• You must show that you actively engaged in a discussion or meeting to get income or some other specific business benefit.
• Entertainment that is held on the same day as the business discussion is considered held directly before or after the business discussion.
Required Documentation
Businesses are required to document all the elements of the business entertainment expense in a timely manner. Such documentation must include the information required in an account book, diary, or similar record. Records of the entertainment must show:
• the person entertained and their connection with the businesss;
• the business purpose;
• the date, time, and place; and
• the cost of the expense.
In addition, the IRS guidelines require receipts for all expenses of $75 or more. Each receipt should include the date, place, person entertained, type of entertainment, business purpose, and business relationship.
FINAL NOTES
The current tax rules have strict deduction limits on entertainment expenses for businesses. While my Sunday at Nationals Park didn’t include any deductible hot dogs (just plenty of water and tax strategy), it proves that with proper documentation and legitimate business purposes, we can still find opportunities in the post-TCJA playbook.
Feel free to contact us to make sure your next client outings both enjoyable and tax-optimized.
