When entertaining clients or traveling on business, you may be eligible for Federal income tax deductions on a portion of your expenses that are not reimbursed by an employer. But the criteria for claiming and substantiating these deductions can be complex, as taxpayers have been known to overstate the travel and entertainment deductions and adjustments to which they are actually entitled. Because the IRS is more likely to audit returns in which deductions for business travel and entertainment are claimed, it is important to follow the guidelines regarding these deductions as closely as possible, while still taking advantage of the opportunity to defray your business costs through these often generous tax breaks.
According to the IRS, taxpayers may deduct “ordinary and necessary business-related expenses” for traveling away from home and entertaining clients and customers. The agency defines an ordinary expense as an expense that is common and accepted in the taxpayer’s trade or business, and a necessary expense as one that is appropriate for the business. The general rule is that taxpayers who deduct these expenses must exclude personal expenses when calculating their deductions, and are required to have documentation to substantiate the expenses. In most cases, only 50% of business meal and entertainment expenses can be deducted.
Moreover, the IRS warns that the expenses “must be reasonable and appropriate,” and that deductions for “extravagant expenses” are not allowable. While this does not mean that you cannot claim deductions for first-class travel or high-priced entertainment, you should be prepared to verify that those expenses were useful in building relationships with clients and increasing sales, and that, for example, dining in an expensive restaurant is customary in your particular business or industry.
If you travel away from home on business for substantially longer than an ordinary work day, you are permitted to deduct related expenses, including the cost of reaching your destination, the cost of lodging and meals, and other ordinary and necessary expenses. The actual cost of meals and incidental expenses may be deducted, or you may use a standard meal allowance and reduced record keeping requirements. Regardless of the method used, meal deductions are generally limited to 50%. Only the actual costs for lodging may be claimed as an expense, and receipts must be kept for documentation.
It is important to keep in mind, however, that travel expenses incurred while away from home and in connection with an existing business are qualified travel expenses, while travel expenses incurred in connection with starting a new business should be added to amortizable start-up expenses.
If the travel is both business and personal in nature, then the rules are more complicated. Assuming the trip was taken primarily for business reasons, the cost of traveling to and from the location is fully deductible, as are the hotel, meals, and other traveling expenses incurred in the business portion of the trip. If, however, the trip was primarily for pleasure, no portion of the travel expenses to and from the destination are deductible, but business-related expenses incurred at the destination are deductible. If you are taking a trip that combines both business and pleasure, you should keep a record of your business activities to substantiate the deductions claimed. If a spouse, child, friend, or relative accompanies you on a business trip, the expenses attributable to his or her travel are not deductible, unless there is a business purpose for the person’s presence.
Expenses for entertaining clients, business associates, or employees may be deducted if they are both ordinary and necessary and meet either the “directly-related” or the “associated” test. The entertainment activity meets the first test if its main purpose was the conduct of business, if business was actually conducted during the activity, and if you have more than a general expectation of deriving income or some other specific business benefit from the activity at some future time. This would include not just restaurant meals with clients at which business was conducted, but also, for example, entertaining clients in hospitality rooms at conventions and trade shows where business was being actively conducted. But if the business discussion is only incidental to the entertainment—such as on a fishing or hunting trip, an outing on a yacht, or at a theater or sports event—the entertainment expenses would not meet the directly-related test. The entertainment activity may, however, meet the associated test if it was associated with the active conduct of your trade or business, and was directly preceded or followed by a substantial business discussion. However, a business discussion is not considered substantial unless you can show that you actively engaged in the discussion, meeting, negotiation, or other business transaction to derive income or some other specific business benefit.
You are generally permitted to deduct 50% of the face value of the cost of tickets to a business-related entertainment event. You may, however, be allowed to deduct the full cost of a ticket to a sporting event that benefits a charitable organization, provided certain conditions are met. The 50% limitation on entertainment expenses also does not apply if you provide meals or entertainment to the general public as a means of advertising or promoting goodwill in the community.
In order to substantiate a business-related travel or entertainment expense, you must be able to document the amount of the item, the time and place the expense was incurred, the business purpose of the item, and your business relationship to the recipient of the entertainment item. When claiming entertainment deductions, you should document the nature of your relationship with the clients or business associates, such as their identities, occupations, titles, or other relevant designations. You must also be able to prove that you or your employee was present at the event.