IRS on the lookout for excessive entertainment expenses
Taking a client out for lunch is one of the most basic business activities there is. And it's one that can run a small business owner afoul of the IRS.
There has been a tug of war for years between the government and businesses over entertainment expenses. The agency is on the lookout for companies that take excessive deductions, or that try to bundle together personal and business expenses.
Barbara Weltman, a tax attorney in Millwood, N.Y., and author of "J.K. Lasser's Small Business Taxes," said this has been one of the most litigated areas in tax law.
What follows is a basic look at the deduction for entertainment expenses. Anyone who wants to claim the deduction should read IRS Publication 463, Travel, Entertainment, Gift and Car Expenses. And it's a good idea to go over these expenses with a tax professional.
Most commonly, people think of business lunches or dinners, or taking clients to the theater, a sporting event or a nightclub. Anyone who has a business and plays golf is also likely to take a client out for a round at a country club. Renting a room and holding a party can constitute a business expense.
But the IRS has rules that can limit the deductions a business owner can take for most forms of entertainment. For example, you can probably deduct the costs of playing golf with your client. But you can't deduct your membership fees at the club.
Reading the rules before you even spend the money on tickets or a meal is a good idea, especially if the event or food is expensive.
The 50 percent rule
A business owner who spends $5,000 a year on business meals and theater or sports tickets isn't going to get a windfall at tax time.
Weltman said one of the biggest mistakes that owners make with the entertainment deduction is that they don't realize they can only claim 50 percent of their expenses. So that $5,000 becomes $2,500 on a tax return, and the tax savings is considerably less.
If your entertainment seems to be too lavish for your circumstances, the IRS might put a limit on how much you can claim. It might question your deductions as agency employees review your return, or it might challenge your expenses during an audit. And you're still subject to the 50 percent rule on the amount the government allows.
There's an old joke about two business people who want to deduct the cost of their dinner out.
"How's business?" one asks.
"Don't ask," is the reply.
So, they move on to talk about anything and everything else, confident that they've satisfied the requirements for a tax deduction.
The IRS doesn't think it's funny. Although many small business owners, as a matter of course, deduct the cost of any meal with a business associate, the government's rules require that the main purpose of a meal or other form of entertainment be "the active conduct of business."
Moreover, it says in Publication 463, an owner must have "more than a general expectation of getting income or some other specific business benefit at some future time."
But the IRS does allow the cost of the meal to be deducted if it takes place directly before or after a business discussion. For example, you meet a client in your office and discuss a new contract. When you take the client out for lunch afterward, the meal should qualify for a deduction.