Costs incurred in entertaining clients, customers, prospective customers, suppliers, employees and other business associates are valid business deductions. However, due to the significant personal nature involved in many of these activities, the expenses are subject to special conditions and restrictions.
They must meet strict substantiation requirements; in addition, amounts otherwise deductible may be limited by a 50% rule.
Entertainment is defined broadly as any activity generally considered as entertainment, amusement or recreation.
A business-related entertainment expense first must qualify as an ordinary and necessary cost of carrying on a trade or business or for the production of income. The expense must be for entertainment either "directly related to" or "associated with" the active conduct of the trade or business.
Directly related to test. To be directly related, the entertainment cost must involve an active discussion aimed at the expectation of obtaining income or some other specific business benefit (other than simply goodwill). The discussion must occur in a clear business setting (such as a meeting, negotiation or transaction) or during the entertainment.
Associated with test. Expenses that do not meet the directly related to test are still deductible if the activity has a clear business purpose and the entertainment directly precedes or follows a substantial bona fide business discussion. An entertainment expense generally is considered associated with a business if the taxpayer can show a clear business purpose (such as obtaining new business or encouraging continuation of a business relationship) for incurring the cost.
Whether a business discussion is substantial depends on the situation. The taxpayer must show that he or she (or a representative) actively engaged in a discussion in order to get income or some other specific business benefit.
Exceptions. Certain entertainment costs are deductible even if they are not directly related to or associated with a taxpayer's trade or business:
- Food and beverages furnished on business premises primarily for employees.
- Goods and services treated as compensation on employees' returns and as wages for withholding purposes.
- Certain reimbursed entertainment costs under an expense allowance arrangement.
- Recreational, social or similar activities provided primarily for the benefit of a taxpayer's employees.
- Expenses connected with meetings of the taxpayer's employees, shareholders, directors or agents.
- Goods, services and facilities made available by the taxpayer to the general public.
- Goods, services and use of facilities sold by the taxpayer to customers for full consideration.
- Goods, services and facilities provided to nonemployees as either compensation or prizes.
For entertainment costs to be deductible, the following must be documented:
- Time, place and nature of the entertainment.
- Amount of each separate expense.
- A description of the business purpose involved.
- Business relationship of the persons entertained.
In addition, further information is required for associated with entertainment:
- Date, place and duration of the business discussion or meeting that took place.
- Nature of the business discussion, the purpose and the benefit derived or expected from the discussion.
- Identification of the people entertained who participated in the business discussions.
For a discussion of current developments in this (and other) areas, see the Tax Clinic, edited by Wilfred Heitritter, in the April 1999 issue of The Tax Adviser.
— Nicholas Fiore, editor The Tax Adviser