Most businesses seek to reduce their tax burden by taking advantage of any deductions available to them. However, it’s important to understand the legal differences between what can be considered a business versus an entertainment expense.
The Internal Revenue Service (IRS) stipulates that business expenses must be ordinary and necessary in carrying out the trade or business in order to be deductible. Deducting meals and entertainment can be a subject of confusion for many since some items are fully deductible, others are limited to 50% and some are non-deductible.
Prior to the Tax Cuts and Jobs Act (TCJA)* established in 2017, taxpayers could deduct 50% of meal expenses and 50% of entertainment expenditures that met the directly related or business discussion exception, which states that the meal or entertainment was directly preceded or followed a substantial and bona fide business discussion. The taxpayers did not need to make a distinction between the two categories.
The TCJA effectively eliminated the deduction for any business entertainment expenses (not including meal expenses). As such, taxpayers should review their accounting on a regular basis and monitor the use of their expense accounts, ensuring that the two categories are separate.
What’s included under “entertainment” expenses?
The term entertainment includes activities that are generally considered to constitute entertainment, amusement or recreation, such as entertaining at a country club, athletic event or concert. Furthermore, dues or membership fees to any social, athletic or sporting club are also included as entertainment and are therefore not deductible.
What’s included under “meal” expenses?
Meals, however, are still deductible, subject to some limitations. Taxpayers may continue to deduct 50% of a business meal expense provided the following criteria are met:
- The expense is an ordinary and necessary expense or incurred in carrying the trade or business
- The expense is not lavish or extravagant
- The taxpayer or a taxpayer’s employee is present when the meal is furnished
- The meal is provided to a current or potential business customer, client, consultant or similar business contact
- In the case of meals provided at an entertainment activity or event, the meal expense is on a separate bill or stated separately from the cost of entertainment on the invoice, bill or receipt
Prior to TCJA, meals provided to an employee for the convenience of an employer were 100% deductible. For tax years beginning in 2018 and after, meals provided for the convenience of an employer in a cafeteria on business premises or elsewhere on the property are only 50% deductible. Beginning in 2026, these meals will no longer be deductible at all.
The 50% limitation does not apply to the following circumstances, which are fully deductible:
- Entertainment expenses treated as compensation (included in employee wages)
- Reimbursed employee expenses
- Recreational activities for employees (such as holiday parties, picnics or outings that do not favor only highly compensated employees)
- Business meetings
- Meetings of business leagues
In addition to satisfying the tests above, IRS regulations require taxpayers to substantiate their expenses. In general, taxpayers must maintain documentary evidence (such as receipts and bills) including the amount spent, the date and location of the meal, the business purpose and the business relationship of those in attendance. This will protect the taxpayer in the event of an IRS audit.
*UPDATE: The Taxpayer Certainty and Disaster Tax Relief Act of 2020, enacted Dec. 27, 2020, includes a temporary provision allowing for a full deduction of business meals paid or incurred during 2021 and 2022.
Special thanks to SST Tax Senior Tania Cruz for providing the content for this post.