Taking current and prospective clients and customers out to dinner, the theatre, or a baseball game can make good business sense — and provide you with a valuable tax deduction. According to the California Society of CPAs (www.calcpa.org), there are two separate tests you must meet to deduct 50 percent of the cost of business meals and entertainment expenses.
Test 1: The Expense Must Be Ordinary and Necessary
To qualify for a deduction, the business meal or entertainment expense must meet the IRS requirement of being "ordinary and necessary." An ordinary expense is one that is common and accepted in your business. A necessary expense is one that is helpful and appropriate to your business.
A salesman who takes a customer to lunch to discuss an upcoming order meets this test and can deduct 50 percent of the cost of the meal because it is customary for salespersons to entertain customers. A bank teller who takes a depositor to dinner does not meet this test because it is not customary for tellers to entertain customers.
Test 2: The Expense Must Be "Directly Related To" Or "Associated With" Your Business.
To pass the next test, the business meal or entertainment expense must be either "directly related to" or "associated with" your business. To meet the directly related test, you must be able to show that the main purpose of the entertainment activity was to engage in the active conduct of a business with the person being entertained.
For example, taking a client to a nightclub, theater, or ice hockey game is likely to fail the directly related test because it is difficult to actively conduct business in these locales. Such entertainment, however, may be deductible if structured to meet the "associated with" test.
Meal and entertainment expenses are "associated with" business if they have a clear business purpose and the entertainment directly precedes or follows a substantial business discussion. For example, if you take someone to dinner to discuss investing in your company, and then go to the theater together, you can write off half the meal cost and entertainment expense. It is not required that more time be devoted to business than entertainment in order to qualify for a deduction. However, your expenses should be reasonable and appropriate for the type of business you are in.
Incidentally, entertainment that is held on the same day as the business discussion meets the IRS criteria for being held directly before or after the business discussion. If the entertainment and the business discussion are not held on the same day, it may be possible to deduct the entertainment costs, but such deductions are more difficult to support.
Good Records Are Critical
The IRS has strict rules for substantiating meal and entertainment expenses. For each expense, you must show the date, place, amount, business purpose of the expense, and the business relationship of the person you entertained. Receipts are required for expenses of $75 or more.
Check with a CPA if you have any questions about deducting or substantiating meal and entertainment expenses.