(UPDATE: For a newer article about entertainment expenses as it relates to sporting events, see here.)
This is the third in a series of posts on tax deductions for small business owners. If you need help understanding some of the specific tax terms that will appear here (like “deduction” and “expense”), see the first few paragraphs of this post.
Let’s say I’m a wedding photographer. After a fun photo shoot, I decide to take the nuptials (who are my friends) out on the town as a wedding present. Is the money I spend tax-deductible?
Tax deductions for “meals and entertainment expenses” are subject to significant restrictions and limitations. To be deductible, the expense must satisfy specific requirements and be properly documented. And even if the expense qualifies and you keep awesome records, only 50% 0f the business portion of the expense is allowed as a tax deduction. Like all deductible business expenses, meals and entertainment must be ordinary, necessary, and reasonable in amount.
And most importantly, the meals and entertainment must be either directly related to or associated with the active conduct of an activity for which the taxpayer has a business purpose.
Which basically means the following things must be true:
- By incurring the expense, you have more than a general expectation of deriving income or a business benefit.
- A bona fide business activity takes place during the meal or entertainment OR the meal or entertainment precedes or follows a substantial and bona fide business activity.
- The main reason for providing the meal or entertainment is to conduct business.
Does it seem like there’s a fair amount of wiggle room in those statements? If you said “yes,” you’d be right. Like most things tax-related, there’s a lot of room for interpretation. The most important thing to remember is: To be legitimately deductible, the money you spend on meals and entertainment must have a bona fide business purpose.
So what about the wedding photographer?
Let’s call our photographer Jane. She took photos at a wedding for people who happen to be her friends, and then decided to take those friends plus a few others out for dinner and a concert as a wedding present. Can Jane deduct those expenses? Let’s see if she meets the rules above.
- Does Jane have “more than a general expectation of deriving a business benefit” from this shindig? This one’s kind of difficult. The clients are Jane’s friends. Because of that, she’s likely to (gasp!) derive some personal enjoyment out of the event. But it’s also fair to assume that Jane’s happy clients and their friends are excellent referral sources of future business. Jane can reasonably expect to derive some benefit from having incurred this expense, which then qualifies it as deductible according to Rule #1.
- The dinner and concert followed Jane’s “bona fide business activity” (the wedding photography shoot). All good on Rule #2.
- Let’s face it: Jane was really giving her friends a gift. “Conducting business” was probably not the main reason for taking them out, even if she does hope to get referrals. So maybe Rule #3 is met. Maybe not. Alas, such is the typical convolution of the U.S. Tax Code.
In a nutshell, Jane could reasonably contend that the costs of taking her friends out to dinner and a concert after their wedding for which she was the photographer are legitimately deductible meal and entertainment expenses. But use good judgment when preparing income taxes, since the rules can’t be clearly interpreted and the IRS may disagree with you.
Please note that this post serves as just a broad overview of deductible meals and entertainment expenses and shouldn’t be relied upon as tax advice. The tax law in this area is very detailed and complex, and can be particularly troublesome for small business owners. It’s also a known area of IRS scrutiny.
For more information, see this clickable index of IRS Publication 463, or talk with your tax adviser.