Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part IV. Business Income and Deductions
Chapter 19. Meals, Entertainment, and Gifts
Everyone Loves Getting a Tax Break for Doing Something Fun
There are many times when a meal, a gift, or entertainment is a very legitimate business expense—just as legitimate as advertising or other promotional expenses. However, there are also many times in which these “business” expenses are really just an excuse to have some fun and get a write-off in the process. Because it is not easy for the IRS to discern between legitimate expenses in these categories, and those that are not, there are strict rules imposed on the record-keeping requirements for these expenses. There are also significant limitations placed on the dollar value that you can deduct for these expenses. In many cases, 50% of the cost is taken right off the top of what you are allowed to deduct. I suppose this is Congress’s way of dealing with—and limiting—the abuse of this deduction. Even so, there are some great opportunities available to save on your tax bill by properly deducting meals, entertainment, and gift expenses.
People seem to love deducting meals as a business expense. It must come down to the fact that they get a tax deduction for something they do every day: eat. Or maybe it gives them the excuse they need to eat out for lunch instead of brown-bagging it. Whatever the reasons people cherish this deduction, you’ll want to understand the tax benefits and risks associated with deducting business meals before you plan your next “business” dinner.
Three categories of meals are deductible as a business expense:
· Meals while on a business trip (a travel expense)
· Meals with a business associate, such as a client, supplier, or vender (an entertainment expense)
· Meals to provide food for your employees
In the first two cases you are allowed to deduct 50% of the cost of the meal, within certain guidelines. However, the rules that determine the deductibility of the meal differ between “travel meals” and “entertainment meals.” In the case of meals for employees, there are instances where the food is 100% deductible.
Meals as a Travel Expense
If the meal is for travel, you have two options for deducting the expense: you can choose to deduct your actual costs (what you paid for the meal), or you can choose to deduct a standard daily amount set by the IRS. With the actual-expense method, you must keep a record of the cost of each meal (including taxes and tips) during your travel. If you choose the standard daily amount, you can deduct one half of the per diem rate that federal employees are allowed to spend each day they travel. This amount differs each year, and it varies based on the city to which you are traveling. In general, the standard-rate for a day’s worth of meals may range between $46 and $71, depending upon location. You can find the rates for each city in IRS Publication 463 or on on this website: www.gsa.gov/perdiem.
If you are not a big spender on food you may get a bigger benefit from claiming the per diem rates and then spending less than the rate. In fact, if you manage to spend one half of the per diem rate you would actually be able to deduct 100% of your meals expense. If the per diem rate for the city you are in is $60, for example, you can deduct 50% of that ($30) as your standard-rate meal expense. If you actually spend only $30 on your food for the day you can effectively deduct 100% of your true expense. If you spend less than half of the standard rate the deal gets even better, allowing you to deduct more than you spent! If you go without food for the day, the government is actually paying you to fast! Maybe I’m going a little overboard here, but you get the idea.
On the other hand, many people will benefit more from the actual-expense method because they spend more on food than the per diem allowance. Check those per diem rates against your own spending habits and determine which method will bring you the best results.
Caution If you use the standard per diem rates, you must use them for every trip during the year. You are not allowed to vary the methods for different trips.
When deducting a meal for business travel, the meal must occur during the time that you are actually conducting business. For example, if you travel out of state for two days of business, but then stay an extra day to sightsee, you can only deduct expenses for meals during those first two business days.
There are special rates for travel outside the continental U.S., as well as unique rules related to those in the transportation industry. Be sure to consult the IRS publications or a qualified tax professional if either of these situations applies to you.
Finally, meals can be deducted for travel only when you are traveling out of town overnight. (The actual guidelines are that you are considered traveling if you are away from the general area of your home for a period substantially longer than an ordinary work day and it is reasonable to expect that during that time you would need sleep or rest.) If you are just away from the office only during a normal working day and buy lunch while you are there, it is considered a personal expense like any other food that you need. However, if you invite a business associate to eat with you, then you may be able to deduct that meal under the meals-as-entertainment rules described in the next sub-section.
Meals as an Entertainment Expense
When deducting a meal for entertainment purposes (such as taking a client to lunch), different rules need to be followed. First, your meal must have a business purpose—you must reasonably expect some benefit to come to your business as a result of the meal. (The benefit doesn’t have to actually occur—you only need a reasonable expectation that it will.) This rule is most easily satisfied by having a business discussion of some significance (more than “So how’s business?”) before, during, or after the meal. In addition, you can deduct the expense only for people connected to your business. For example, you couldn’t invite your client to a family reunion and then deduct the meal expense for your 10 cousins who joined you—only the cost of the meals for you and the client could be deducted.
Tip An exception: You are allowed to deduct a meal for your spouse if you have brought him or her along to make the spouse of your business associate feel comfortable. This is considered a reasonable business expense.
Caution You or your employee must be present at the meal in order to claim it as a business expenses. For example, you could not send a restaurant gift certificate to a client and deduct it as a business expense. Such an expense would fall under the gift rules instead, which are much more limited (as discussed at the end of this chapter).
The timing of the business discussion in relation to the meal (or entertainment) is important. If the “discussion” happens during a rock concert it won’t count, because it would have been too loud for a serious business discussion. Also, if the discussion happened after a significant amount of alcohol is consumed it probably will not count either.
There is not a per diem alternative for meals-as-entertainment like there is for meals when traveling. You can deduct only the actual cost of the meal. In addition, the cost of the meal must be seen as reasonable under the circumstances (not lavish or extravagant) or the IRS can actually reduce it to a reasonable amount. (I think it would have to be pretty extreme for the IRS to challenge it. There is no exact number given, but I think common sense would rule in this case. Is it an ordinary and reasonable expense under the circumstance?)
Note If food is provided as part of an event where attendees pay to participate (such as a trade show, conference, or entertainment), the meals are deductible as part of the cost of an event that generated revenue for the business.
Food provided freely to the public as part of a promotional event is fully deductible because it is more of an advertising expense than entertainment.
Because of rampant abuse of the meals deduction, the IRS strictly enforces its record-keeping rules for these expenses. You must keep a record of the following five items for all meal expenses you deduct for entertainment purposes (when you pay for a meal for someone other than yourself ):
· The date of the meal
· The cost of the meal, including taxes and tips.
· The place where the meal was purchased
· The business purpose of the meal—state whether the business conversation was held before, during, or after the meal, and what the conversation’s business goal was.
· The business relationship you have with the people whose meals you paid for. List their names and any other information necessary to establish that they have a business relationship with you.
Interestingly, the IRS does not require any receipts for meals that cost less than $75. That said, you do need all of the information I listed, even if you don’t keep a receipt. For practical purposes I recommend keeping receipts for all of these expenses. That way you are in the habit of doing this and you don’t have to think about when to keep a receipt. Plus, three of the five record-keeping requirements are already on the receipt (date, cost, and place), so you can just write the purpose of the meal and the people involved on the back of the receipt, and you have a complete record.
For meals related to travel you only need the first two items on the list. If you use the per-diem rate you don’t need any records of the items on the list. However, in both cases you do need proof that you were actually traveling for business purposes when those meals occurred.
Before you get too excited about this deduction and set up all kinds of business meals on your calendar, remember that the tax benefits of this deduction are pretty limited. First, the tax code eliminates half the cost of the meal right off the top by only allowing you to take a 50% deduction. Then the true benefit of the remaining 50% depends on your marginal tax bracket. If you are in the 15% bracket, your deduction equates to a 7.5% break on the total cost of your meal (the cost of the meal × 50% × 15% = 7.5% savings). In the best-case scenario, the highest amount that you might take off the cost of the bill through the tax savings is 34%. For that scenario to occur you would have to be self-employed, in the highest tax bracket, and living in a very-high tax state like California (15.3% self-employment tax + 39.6% federal tax + 3.8% additional Medicare tax + 9.3% state tax = 68% total tax bracket × 50% of the cost = 34% savings). Don’t get caught in the mindset that a deduction for your meals means the government is footing the bill. You are still paying for most of it.
Caution I can’t stress enough the importance of good recordkeeping when it comes to this deduction. Because of a long history of abuse in this area the IRS will heavily scrutinize your meal expenses if they audit your return. If you have the records they require, you will be in good shape. If you don’t . . . well, it might spoil your dinner if I talk about it.
Meals for Employees
If a business provides meals to its employees for the employer’s convenience, the meals may be 100% deductible and not included as additional pay to the employees. To be deductible the meals must fall into one of the following categories:
· Employer Convenience. This occurs when an employer needs the employee to remain on site for business reasons. If more than 50 of the employees are provided the meals for this reason it is considered that all the meals provided are for this purpose. Examples of this would be to attend a mandatory business meeting, meet with a client or customer, or to trade securities while the market is open. This could also occur to help the employees work late or on holidays, or if there are no available eating facilities within a reasonable distance where the employee could travel to and return within the allotted time frame for meals. (Meals provided to owners, 10% shareholders, officers, or directors are not deductible under the “employer’s convenience” rules unless they are included in that individual’s income, unless for a business meeting.)
· Employer Events. If the business is providing a recreational or social activity for employees where food is provided, these meals are generally fully deductible. Examples of this would be a company picnic or holiday party. However, the food costs must be reasonable. In some cases, such as high-end holiday parties, the cost of the food is extraordinary and would not qualify for the full deduction.
· Employee Goodwill. Nominal gifts of food to employees. Classic examples of this would be giving employees a turkey at Thanksgiving or ham at Easter.
· Minimal, Hard-to-Track Items. Food and drink items provided in the workplace that have a minimal value and are hard to trace to a specific employee are fully deductible. For example, if an employer provided free soft drinks and snacks, these items would be fully deductible.
· Reimbursed by Client. If a business tracks meal expenses and bills them to a client for reimbursement, those costs are deductible (and the reimbursement is included in income, so it is a wash).
· Restaurants, Non-Luxury Water Vessels and Offshore or Alaskan Oil Rigs. These employers are allowed to provide meals to their employees and fully deduct the costs.
To claim the full deduction of employee meals, the expense must be directly for food (i.e., no reimbursements or cash advances, etc.). Also, the food cannot be a reward or incentive (which would be considered compensation). In these cases the meals would be considered a form of payment and be included in the employee’s W-2 form as compensation. (However, if the meals are included as employee income they are fully deductible to the employee.)
Note Food provided to spouses and children of employees at a company event is also deductible—the deduction is not exclusive to the employees only.
The rules governing entertainment expenses are almost identical to those governing “meals-as-entertainment” expenses. Entertainment would include such expenses as nightclubs, sporting events, theaters, and so on. To deduct such expenses the business must have more than a general expectation of deriving income or another specific business benefit to come from providing the entertainment, at some time in the future.
In addition, the entertainment must occur immediately before, after, or during a substantial business discussion. The business discussion must be the principal purpose of the business and entertainment and must represent an active effort by the business to obtain income or another specific business benefit. The entertainment can either be with a current client or customer or with a potential new business prospect.
There are a few types of entertainment expenses that are specifically not deductible. Some of the more common ones are:
· Entertainment facilities, such as yachts, swimming pools, hunting lodges, bowling alleys, etc.
· Club memberships, such as social, athletic, sporting, business, and other similar clubs. (Clubs that have a non-entertainment or social purpose, such as Kiwanis or Rotary, are deductible, as well as professional organizations with a business focus.)
Other than the specific differences that I have noted to this point, entertainment expenses are deductible at 50% of their reasonable cost and follow the rules noted in the meals-as-entertainment section. In addition, reasonable entertainment provided at an employee event (such as a picnic) is fully deductible, along the same lines as are mentioned in the section about employee meals.
The record-keeping requirements for entertainment expenses are stringent. They are identical to the meals-as-entertainment record-keeping requirements that are listed in the previous section. Take the time to keep these records so that the deductions will be upheld. Also take special note of the “Cautions” regarding timing listed in the meals section. The timing of the business discussion and the entertainment could end up countering the argument that the primary purpose was for business if the likelihood of a serious discussion happening is slim because of the circumstances, or if the business representative is not present during the entertainment.
Business gifts are subject to very limiting rules regarding their deductibility. You cannot deduct more than $25 in gifts to any household in a year, no matter how much you give them or how business-worthy the gift was. If you send a client a $500 gift you can deduct only $25. This doesn’t mean you shouldn’t give larger gifts—you just need to know that you cannot deduct that expense from your taxes.
The gift limitation applies whether the gift is given directly or indirectly. For example, if you give one gift to a client and another to his wife (or child, etc.), it is treated as if you gave the gift indirectly to the client (unless you have a clearly separate and independent business relationship with that family member). Likewise, if you give a gift to a business with the intent that a certain individual receive the benefit of that gift, it is counted as an indirect gift to that individual.
Example Dillon’s best client is Milton, a local business owner. At Christmas time, Dillon gave Milton a $100 gift certificate to his favorite restaurant and also gave a $50 silk scarf to Milton’s wife. Dillon also sent a $120 gift basket full of food to Milton’s business office, which Milton took home to his family. Dillon’s total gifts to Milton were worth $270. All of them are treated as being given directly or indirectly to Milton, so Dillon will be allowed to deduct only $25 of that expense.
In addition, you and your spouse are counted as one giver of a gift (or gifts), so you cannot each give a gift to an individual and receive two deduction limits for those gifts. This is the case even if you and your spouse have separate businesses!
Inexpensive, incidental items are not included in the $25 limitation and are fully deductible. Incidental items would include such things as engraving, packaging, gift-wrapping, mailing, and insuring items. The key to being incidental is that it does not add substantial value to the gift.
Inexpensive items that are clearly promotional in nature are not considered gifts (such as a pen with your company logo on it). To qualify as a promotional item, its value must be less than $4 per item. The item must have your business name clearly printed on it, and it must be something that you distribute widely to many people.