On a recent business trip to Indianapolis, you decide to take a client out for dinner, drinks and to a Pacers’ game. It’s win-win: you have a good time and you use the opportunity to earn some goodwill to promote your business. It’s a no-brainer that that expense is deductible, isn’t it? Well, as the lawyers are fond of saying, “it depends.” The IRS estimates that $30 billion in taxes is underpaid due to improperly deducted or overstated business expenses. As is usual with IRS-related items, the regulations and rules are rather dry and technical, but a general overview should help keep your business on the right side of the law and you sleeping a little better at night if your company is audited.
Travel Expenses
The general rule for business travel is that all ordinary and necessary business expenses when traveling away from home for business are deductible. An “ordinary expense” means one that is common and accepted in your industry. A “necessary expense” is one that is helpful and appropriate for your trade or business, but need not be, strictly speaking, indispensable. These expenses are fairly broad, but include, generally:
- the cost of transportation to get to the business destination (airplane or train tickets to get to your destination);
- transportation once you arrive at the general destination (taxiing from the airport or station to your hotel and from your hotel to a business location, or a business-related rental car or car maintenance expenses when traveling);
- lodging;
- meals (subject to certain limitations discussed below);
- dry-cleaning; and
- tips related to the foregoing expenses.
As with all general rules (and particularly with IRS rules), there are exceptions and limits.
How much of your trip is for business? The general rule above assumes that you are traveling exclusively for business, but what if you stop by your aunt’s or college roommate’s house while you are in Indianapolis? As long as your trip is primarily for business, you can deduct all of your business-related travel expenses, including the costs of getting to and from the business destination. In other words, the cost of the flight to Indianapolis? Deductible. The taxi fare to get from the hotel to your aunt’s? Non-deductible. If, however, your trip is primarily for personal reasons, your travel expenses are non-deductible, and only your expenses directly related to business are deductible. The plane tickets will be non-deductible, but the cost of a taxi ride to a client’s office will be deductible.
Lodging and meals while traveling. The costs of lodging and meals are deductible as travel expenses when your business trip is overnight or long enough that you need to stop for sleep or rest to properly do your work. In other words, if your meeting in Indianapolis starts at noon and you could fly there that morning, the costs of lodging the night before are probably non-deductible. If the meeting starts at 8:00 a.m., the costs of lodging and dinner the night before would be deductible. Meals, in either case, are subject to an additional 50 percent limitation discussed below.
Entertainment Expenses
Entertainment expenses are defined fairly broadly, including providing entertainment, amusement, recreation, and even providing drinks and meals (which is distinguished from meals as a travel expense, discussed above) to employees, clients or other parties with whom you do business. In general, you can deduct the ordinary and necessary costs of entertaining employees, clients, or potential clients if you meet one of two tests: theDirectly-Related Test and the Associated Test.
The Directly-Related Test only allows you to deduct entertainment expenses if 1) the main purpose of the entertainment was the active conduct of business, 2) you engaged in such business, and 3) you had a specific expectation of a specific business benefit. Moreover, if the environment contains distractions that would ordinarily prevent the active conduct of business, it is generally not directly-related. In a nutshell, a golf game where you make a sales pitch would probably be directly-related, but the Pacers’ game is a closer call of whether the Directly-Related test is satisfied.
The Associated Test is a bit easier to meet. Entertainment generally meets the Associated Test if such entertainment is associated with the conduct of your business and a substantial business discussion occurs on the same day as the entertainment. In other words, if you discussed business significantly with the client the afternoon before the Pacers’ game, then the Pacers’ game (and any meals or drinks before or after) would be deductible.
Meals. Two major exceptions apply to meals, whether as a travel expense or as an entertainment expense: 1) meals cannot be lavish or extravagant, and 2) most meals are only deductible up to 50 percent of the actual cost of the meal. “Lavish and extravagant” isn’t clearly defined, but is only reasonable under the circumstances. If you are deducting a meal as an entertainment expense for the CEO of Ford, a steak and lobster dinner probably won’t be lavish and extravagant; if you are deducting a meal as a travel expense for yourself as you stop overnight in Omaha, a more modest meal is recommended. The 50 percent limitation applies generally, though there are some exceptions: in particular, employees who are reimbursed by their employer are usually allowed to deduct the entirety of their meals.
Recordkeeping
Just because a business expense is generally deductible doesn’t mean that you are free and clear. The IRS has fairly specific recordkeeping requirements to substantiate your expenses. If your business has employees, you need to put a plan into place to make sure you meet the IRS requirements if they do come knocking.
The general rules require you to establish the amount of the expense, the date of the expense, the place of the expense and the business purpose or business relationship promoted by the expense. Documentary evidence is required to substantiate these expenses: hotel or restaurant receipts or cancelled checks, along with a bill, are usually sufficient to sufficient to establish the amount, date, and place of the expense, although the business purpose must be established independently. Keeping contemporaneous records is essential. An account maintained daily (or within no more than a week or two after the expense is incurred) is far more effective at establishing the validity of the expenses than an account put together only at tax time (or worse, after the initiation of an audit).
Conclusion
Naturally, these rules just scratch the surface. Different rules apply if you travel abroad, and specific rules apply to travel by boat, conventions, luxury suites, and numerous other items