Finance: Traps on Expense Reports
Know the Rules of the Road — and the Restaurant — to Avoid TroubleQuestions continually arise regarding various types of employee expenses, reporting requirements, and the deductibility of certain kinds of expenses. With heightened scrutiny by the IRS, it can be difficult to determine whether or not a meal, entertainment event, or a travel expense qualifies for a tax deduction. This article will describe the most common expense reimbursements paid by employers, as well as the deduction rules and reporting requirements mandated by the IRS.
Meals and Entertainment
The IRS requires a taxpayer to jump through a number of hoops in order to qualify for this deductible expense. Once the documentation requirements are met, the deduction is limited.
In order for meals and entertainment expenses to qualify for the deduction, the expense must first be an ‘ordinary and necessary’ business expense. This criteria is not exclusive to meals and entertainment; rather, all business expenses must meet the general deductibility requirement of being ordinary and necessary. This term is broad and implies customary or usual in carrying on business. Therefore, if it is reasonable in your business to entertain clients or other business people, you should pass this test.
Second, the expense must be ‘directly related to’ or ‘associated with’ the business. ‘Directly related to’ involves an active discussion with the anticipated result of gaining immediate revenue. Here, as a business owner or employee of a business, you must anticipate receiving a specific concrete business benefit. General goodwill or making a client, customer, or associate view you in a favorable light will not qualify under this test. Further, the principal purpose for attending this event must be business, and you must be actively engaged in business discussion during the event or meeting.
Alternatively, the ‘directly related’ test can be met if the meal or entertainment takes place in a clear business setting, in furtherance of your business. Meetings or discussions that take place at venues such as sporting events, nightclubs, or cocktail parties (i.e. social events) would not meet this test.
However, if the ‘directly related’ test cannot be met, the expense may still qualify under an alternative ‘associated with’ test, where the expense may qualify if it is associated with the active conduct of business, or if the meal or entertainment event precedes or follows (basically takes place on the same day as) a substantial and bona fide business discussion. This test is much easier to satisfy, because it allows the ‘goodwill’-type entertainment, such as the sporting event, nightclub, or cocktail party referenced earlier, to qualify as serving a business purpose.
The event will be considered ‘associated with’ the active conduct of a trade or business if its purpose is to get new business or encourage your existing clients or customers to continue their business relationship with your company. For meals, the owner or an employee of the company must be in attendance at the event. This means that, if you simply cover the cost of a client’s meal after a business meeting but you do not join him or her, that expense will not qualify as a deductible business expense.
Assuming the expense meets the ‘directly related’ or ‘associated with’ test, the expense must then be adequately substantiated to prove that it qualifies as a deductible business expense. The use of reasonable estimates is not sufficient to stand up to an IRS challenge; you must be able to establish the amount spent, the time and place, the business purpose, and the business relationship of the individuals involved.
Careful and detailed recordkeeping procedures should be maintained in order to keep track of each business meal and entertainment event, and the justification for its business connection. Further, for expenses of $75 or more, documentary proof (such as a receipt) is required.
Once the business purpose test is met, the expenditure is subsequently limited to a 50% deduction. For example, if you spend $2,500 per year on meals and entertainment, only $1,250 will be deductible, further limiting the tax benefit of business meals and entertainment.
Another area of heightened IRS scrutiny is auto-related deductions. The business standard mileage rate is the most common method of reimbursing an employee’s auto expense. Reimbursements based on the business mileage rate are in lieu of reimbursing employees for the actual fixed and operating costs, such as depreciation, maintenance, fuel, etc.
If an employer pays an employee a mileage reimbursement, this reimbursement may be excluded from income provided that the time, place, and business purpose for the travel are substantiated. This substantiation must meet or exceed the amount of allowance paid by the employer. Proof generally is made by substantiating the dates, location, miles, and business purpose of the travel. For 2011, the optional standard mileage rate is set at 51 cents per mile for business use through June 30, 2011 and 55.5 cents per mile on or after July 1, 2011.
If, however, the allowance paid to the employee exceeds the actual substantiated mileage rate, the excess must be treated as taxable compensation on the employee’s W-2. It is important to note that not only employees, but business owners must comply with the substantiation requirements for mileage allowances. Even though there may be no question as to the deductibility of the expense, the expense may be disallowed by the IRS for lack of contemporaneous documentation to properly substantiate the expense.
Business deductions are allowed for business conducted out of town, which reasonably requires an overnight stay. The actual cost of travel, including plane fare, cab fare to the airport, etc., are deductible, in addition to the cost of meals and lodging. Meals will be deductible even if they are ‘personal,’ (not connected with business), although they will again be limited to the reduced deduction (generally 50%).
Personal entertainment costs incurred on the trip are not deductible, but business-related costs such as dry cleaning, phone calls, or computer rentals will be deductible. Further, if a meal or lodging expense is considered ‘lavish or extravagant,’ a term interpreted to mean ‘unreasonable,’ no deduction will be allowed.
If you combine business and pleasure on a trip, it will be necessary to allocate deductible versus non-deductible business expenses. For example, if you fly to a location for five days of business meetings and stay for an extended period of vacation, only the costs of meals, lodging etc. for the travel days pertaining to business are deductible. The IRS does not allow deductions for expenses incurred during personal vacation days.
However, with respect to the travel itself (plane fare, for example), if the trip is ‘primarily’ business, the travel cost is fully deductible. Alternatively, if the trip is primarily personal, none of the travel costs are deductible. A significant, but not exclusive, factor in determining the primary purpose of the trip is the amount of time spent on each. The IRS has heightened scrutiny surrounding conventions and seminars. They will check the nature of the meetings carefully to determine if they are vacations in disguise. It is important to save all materials helpful in establishing the business or professional nature of the travel.
In addition, the rules for deducting costs incurred for a spouse accompanying an employee or business owner on a trip are very restrictive. No deduction for additional spousal travel costs will be allowed unless the spouse is an employee and there is a business purpose for the travel. Moreover, personal expenses incurred at home as a result of taking a business trip are not deductible. For example, pet boarding while away is not a deductible business expense.
This article is intended to give some general guidance surrounding deductibility of business expenses. As always, you should consult your tax advisor or legal advisor before applying this general information to your specific tax situation.
Jennifer Reynolds is a tax manager with the certified public accounting firm Meyers Brothers Kalicka, P.C., in Holyoke.