By Gary A. Hensley
Self-employed writers, authors, researchers, illustrators and literary agents may be able to deduct business-related entertainment expenses for entertaining a client, customer, or employee. You can deduct entertainment expenses only if they are both ordinary and necessary and meet one of the following tests:
- Directly-related test
- Associated test
First, let’s define ordinary and necessary below:
- An ordinary expense is one that is common and accepted in your trade or business.
- A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be required to be considered necessary.
If you meet both of the above tests, you now must meet one of the following tests:
- Directly-Related Test. To meet this test, you must show that: (1) the main purpose of the combined business and entertainment was the active conduct of business; (2) you did engage in business with the person during the entertainment period; and (3) you had more than a general expectation of getting income or some other specific business benefit at some future time. Entertainment in a clear business setting is presumed to meet the directly related test. You will be presumed to have failed the directly related test if you are on a hunting, skiing, or fishing trip or on yachts or other pleasure boats unless you can show otherwise. Other locations that are presumed to have failed the directly related test include nightclubs, golf courses, theaters, and sporting events.
- Associated Test: Even if your expenses do not meet the directly-related test, they may meet the associated test. You must show that the entertainment is: (1) associated with the active conduct of your trade or business; and (2) directly before or after a substantial business discussion. How do you know if a business discussion is substantial? There is no quantitative way to prove this. There is no required amount of time you must spend meeting or discussing business, and you do not have to devote more time to business than to entertainment. You are not required to discuss business during the entertainment itself. You must be able to show that you actually held a business discussion to get income or other business benefit. Goodwill entertainment satisfies the associated test.
Finally, you must show that the cost of the entertainment was not lavish or extravagant. [Example: Limitations apply to skyboxes and other private luxury boxes]. There are no dollar figures used in making this determination; rather, it is based on the facts and circumstances.
In general, you can deduct only 50% of your business-related meal and entertainment expenses. The 50% limit applies to employees (or their employers) and to self-employed persons (including independent contractors) or their clients, depending on whether the expenses are reimbursed. [See Tax Tip below to avoid the 50% limitation under certain conditions].
The 50% limit applies to business meals or entertainment expenses you have while:
- Traveling away from home (whether eating alone or with others) on business,
- Entertaining customers at your place of business, a restaurant, or other location, or
- Attending a business convention or reception, business meeting, or business luncheon at a club.
Other expenses subject to the 50% limit include:
- Taxes and tips relating to a business meal or entertainment activity,
- Cover charges for admission to a nightclub,
- Rent paid for a room in which you hold a dinner or cocktail party, and
- Amounts paid for parking at a sports arena.
Note: The cost of transportation to and from a business meal or a business-related entertainment activity is not subject to the 50% limit.
Tax Tip (Transferring the 50% limit)
Your meal or entertainment expense is not subject to the 50% limit if you meet one of the following exceptions:
- If you are an employee, you are not subject to the 50% limit on expenses for which your employer reimburses you under an accountable plan (meaning you report all your business expenses to your employer and are reimbursed in full). You receive full reimbursement for your expenses (a “wash” for you–no income; no expense) and the employer is now subject to the 50% limitation on the expenses you incurred on its behalf.
- If you are self-employed, your deductible meal and entertainment expenses are not subject to the 50% limit if all of the following requirements are met:
- You have these expenses as an independent contractor;
- Your customer or client reimburses you or gives you an allowance for these expenses in connection with services you perform; and
- You provide adequate records (receipts, explanations) of these expenses to your customer or client.
In this case, your client or customer is subject to the 50% limit on meals and entertainment expenses. Therefore, if you accept an assignment that will involve significant (or even moderate) travel, meals and entertainment, you should prepare the bid or contract with a breakdown for professional fees and a capped travel allowance (which you will receive during the assignment upon providing the proper documentation). This strategy will give you 100% coverage on your assignment travel expenses including meals and entertainment. If handled properly, you will “pass-through” the travel, lodging, meal and entertainment costs to your customer or client and be fully reimbursed. You will not claim these expenses on your tax return nor will you report the reimbursement as income from your customer or client. You will only report the professional fees paid to you.
If you are working on your own endeavors and not for a third-party, the 50% limitation would apply to your business meal and entertainment expenses. On Schedule C, for sole proprietors, there is a separate expense line for “deductible meals and entertainment.” The allowed 50% amount gets reported on that line.