One deduction that almost every business can utilize is the meals and entertainment (M&E) deduction. Even though the rules seem pretty straightforward, the expenses require a taxpayer to pay careful attention to certain aspects of these rules and determine whether any portion of the deduction or the whole deduction may be limited. The following are some of the key rules to beware of when determining deductibility and classification of these expenses.
For any expense to be deductible, it must be ordinary and necessary. An ordinary expense is one that is "common and accepted in your industry," and a necessary expense is one that is "helpful and appropriate for your trade or business." These first few rules and definitions seem simple enough, but as we get toward the bottom of the list, you will see that the rules are not as black and white.
The expenses must also have a business connection. For an expense to have a business connection, it must pass the directly related or associated test:
- Directly related test: Directly related refers to the principal purpose of the entertainment expense having to stem from a business-related activity, including an active discussion with the purpose of generating revenue or a meeting taking place in a clear business setting directly associated with your business.
- Associated test: If your expense does not meet the directly related test requirements, it still may be eligible under the associated test. This test looks to make sure that the purpose of the expense is to enhance the continuation of business relationships or to generate new business. The expense must occur directly before or after a substantial business discussion.
As with any business-related expense, you must be careful to retain records because the expenses must be substantiated. Records can be items such as receipts, credit card statements, or invoices, to name a few and must include the following:
- Amount of each separate meal and entertainment expense
- Name and address of place of entertainment
- Type of entertainment
- Business purpose
- Nature of business discussion
- Name and title of person entertained to establish business connection
After determining all the above criteria, the expense itself must be analyzed. Based on the type of expense, amount, or how it was incurred, the deduction may be limited. Some examples based on the IRS guidelines (not meant to be all inclusive) are as follows:
- Expenses not deductible:
- Expenses 50 percent deductible (generally, most business-related M&E expenses):
- Expenses 100 percent deductible:
- De minimis fringe benefits excludable from employee’s gross income (i.e., coffee, fruit, snacks in business)
- Lavish and extravagant portions of expenses
- Club dues and membership dues if the principal purpose of the organization is entertainment or to provide entertainment facilities for members (i.e., country clubs, golf clubs, airline or hotel clubs)
- Expenses relating to the use of entertainment facilities (i.e., yacht, hunting lodge, swimming pool, vacation home, airplane), however, you may deduct the out-of-pocket expenses related to food and beverages at these facilities based on the above tests
- Client or customer entertainment, including meals and events, such as sporting events, ticketed events, or golf outings
- Networking events
- Meals (including taxes and tip) for employee while traveling or at conferences
- Meals with employees (unless for a specific event listed under 100 percent deductible)
- Tickets to charitable fundraising events
- Expenses related to recreational or social activities incurred primarily for the benefit of employees (i.e., company picnic, holiday party, professional sporting events; cannot discriminate in favor of highly compensated employees)
- Expenses for items made available to the general public (i.e., snacks at a car dealership)
- Meals and entertainment included in the gross income of a non-employee and substantiated by a 1099 (i.e., a sales promotion that awards a customer with a dinner cruise).
- Expenses for tickets to a fund-raising charitable sporting event (for the benefit of a 501(c)(3) organization that receives 100 percent of the profits and volunteers are used for substantially all the work in staging the event) (i.e., golf tournament, with all proceeds donated to a charity)
- Employee recognition expenses (i.e., birthday lunches, award dinners, welcome/retirement gatherings)
- Career development expenses (i.e., mentor lunches, goal-setting meetings)
- Lunch or dinner meeting expenses for the convenience of the employer (i.e., delivered pizza for employees or boxed lunches for lunch and learn development programs)
- Expenses incurred for overtime work meals
- Items treated as compensation to an employee and substantiated by W-2 (i.e., incentive trips, club dues, or performance awards)
As you can see, almost every business can utilize the M&E deduction based on the qualifications listed above, but be sure to pay careful attention to whether the deduction may be limited.
If you have questions about your dealership’s meals and entertainment expenses, contact your Baker Tilly tax advisor.
Note: This article is not meant to and therefore does not discuss the determination of whether certain meals and entertainment expenses should be employee compensation (and therefore included on a W-2) or nonemployee compensation (and therefore included on Form 1099).