Not All Meals Are Equal
Fully Digesting What the Terms ‘Ordinary,’ ‘Necessary,’ and ‘Reasonable’ Mean
It is early one evening, and youre finishing a great dinner at a local restaurant with a colleague. The waitress brings the check, and you reach for your wallet. As you ponder which credit card to put it on, business or personal, you probably dont realize the complex, sometimes contradictory rules that apply to deducting business meals and entertainment expenses.
These rules go far beyond the IRS limitations which allow only a 50% deduction for meals and entertainment expenses. There are many rivers to cross before that bridge.
The deductibility of any cost incurred for business entertainment or meals is governed by the long-established requirement that the expenditure be an ordinary, necessary, and reasonable expense bearing a proximate relation to the taxpayers business or income-producing activity. Under an equally well-embedded principle, however, no deduction is allowed with respect to personal or family expenses.
Over the years the courts have struggled to balance these countervailing principles by attempting to distinguish those expenditures that are business-related and deductible from those that are personal in nature and thus non-deductible.
The term ordinary and necessary does not lend itself to a ready definition. Countless cases that have attempted to determine whether an expense was in fact ordinary and necessary with respect to a particular taxpayer have considered whether a hard-headed businessman would have incurred it under the circumstances. This common-sense test lends a degree of objectivity to the statutory formula, and is helpful in rationalizing the occasionally inconsistent results reached by the courts. If the taxpayer is an employee and incurs unreimbursed entertainment costs to benefit his employer, the expenditure, to be deductible on the individual level, must be an ordinary and necessary expense of the taxpayers earning his salary as an employee. In general, this requires a showing that the employer required or expected the employee to bear these expenses himself and that the expenditures were not reimbursable by the employer.
With respect specifically to promotional costs, including those for entertainment or meals, the case law recognizes as a general proposition that providing amenities of this nature to customers, clients, or business colleagues of a taxpayer is generally conducive to bettering the taxpayers business, and that this is not an unusual or uncustomary occurrence. Nevertheless, the taxpayer must be prepared to demonstrate that, with reference to the particular business conducted by the taxpayer, the expense was ordinary. For an employee, generating goodwill falls short of the necessary requirements.
The term necessary means that the expenditure must be appropriate and helpful for the development of the taxpayers business. Under this definition, the expenditure need not be indispensable to ones business, but it must be made with the intention of securing a business benefit. If the taxpayer can demonstrate that a business benefit was intended or resulted from the expenditure, any incidental personal benefit is disregarded; conversely, if the expenditure was primarily of personal or social benefit and only incidentally business-related, it is not deductible. Since expenditures for entertainment or meals are usually of mixed business and personal benefit to the taxpayer, they are especially susceptible to attack as lacking a business relationship.
Perhaps you are feeling positive that the expense passes the ordinary and necessary requirements. You are not yet insured a tax deduction. To be deductible, the expense must be not only ordinary and necessary but also be either directly related to or associated with the active conduct of the taxpayers trade or business.
Directly related entertainment usually involves a business discussion that should result in income or some other business benefit at some specific time in the future. This discussion can take place during the entertainment or in a clear business setting.
Associated with requires that a substantial business meeting must have taken place before, between, or after the entertainment activities and that the entertainment was associated with the active conduct of a trade or business.
IRS rules state that entertainment or food and beverage expenses incurred in a clear business setting directly in furtherance of the taxpayers trade or business are deemed directly related.
IRS rules provide for an objective, rather than a subjective, standard to determine whether there was a clear business setting for the entertainment or meals. Thus, entertainment occurring in distracting circumstances is presumed not to have occurred in a clear business setting and is deemed socially, rather than commercially, motivated. IRS guidance cites the following examples of settings which might not be a clear business setting:
A meeting or discussion taking place at a nightclub, theater, or sporting event, or during essentially social gatherings such as a cocktail party; or
However, the Congressional Committee Reports indicate by way of illustration that Congress intended to allow the deduction of entertainment expenses as associated with the active conduct of a trade or business if the taxpayer conducts substantial negotiations with a group of business associates and that evening entertains them and their wives at a restaurant, theater, concert, or sporting event. In this case, the entertainment expenses are considered associated with the active conduct of the business, and are deductible, even though the purpose of the entertainment is to promote goodwill.
So, having that said, a sporting event or theater would not be directly related but would be associated with. No wonder taxpayers get lost in these rules.
IRS rules create a rebuttable presumption that the active conduct of trade or business is not the principal character or aspect of combined business and entertainment activity on hunting or fishing trips, or on yachts and other pleasure boats, and requires the taxpayer to clearly establish to the contrary, to meet this test under those circumstances.
Assuming a taxpayer meets the threshold tests of demonstrating that the entertainment or meal cost represents an ordinary and necessary business expense and then shows that the expense satisfies (or is excepted from having to satisfy) the directly related test or the associated with test, it must still meet the rigorous substantiation requirements. In essence, the rules bar any deduction for an expenditure on the basis of the unsupported testimony of the taxpayer or on the basis of his approximations.
Accordingly, to secure any portion of the deduction, the taxpayer must substantiate all entertainment and meal expenses by adequate records or sufficient evidence corroborating his own statement as to (1) amount, (2) time and place, (3) business purpose, and (4) business relationship of the person entertained. The substantiation requirements are strictly construed, and the taxpayers failure to satisfy their particulars entails complete disallowance of the deduction.
All this said, dont forget that most meals and entertainment expenses, if deductible, are limited to a 50% deduction. Additionally, expenses related to an entertainment facility or membership are not deductible at all, but the cost of separately stated expenses incurred at such a place may be deducted subject to the above limits including the 50% rule.
Kristina Drzal-Houghton, CPA, MST is partner in charge of Taxation at Meyers Brothers Kalicka in Holyoke; (413) 536-8510.