Entertainment includes any activity generally considered to provide entertainment, amusement, or recreation (Regs. Sec. 1.274-2(b)(1)). Meal and entertainment expenses incurred by a taxpayer to entertain a client, customer, employee, or other business associate are deductible only if the expenses satisfy the following strict requirements imposed by the Code:
- Ordinary and necessary: Meal or entertainment expenses must be ordinary and necessary to be deductible (Sec. 162(a)). An ordinary expense is one that is common and accepted in the taxpayer's business, trade, or profession. A necessary expense is one that is helpful and appropriate, although not necessarily indispensable, for the employer's business, trade, or profession.
- Business connection: There must be a clear connection between the meal or entertainment and a business event (such as a discussion, meeting, transaction, or negotiation). That is, the taxpayer must prove a valid business purpose for the business event that occurs before, during, or after the meal or entertainment activity (Sec. 274(a) and Notice 87-23).
- Lavish or extravagant: The meal or entertainment cost is deductible only to the extent it is not lavish or extravagant under the circumstances. Any portion deemed to be lavish or extravagant is not deductible. The remaining portion is deductible (Sec. 274(k)).
- Substantiation: A deduction is allowed only for meal or entertainment expenses that are properly substantiated (Sec. 274(d)). No substantiation means no deduction.
- Taxpayer's presence: The taxpayer or a representative must be present when the activity involves business meals. Otherwise, the cost of the meal is nondeductible (Sec. 274(k)).
Of these requirements, the business connection requirement imposed under Sec. 274(a) is perhaps the most difficult to meet. This requirement focuses on the reason for which the taxpayer's expense is paid or incurred and requires a business connection between the expense and the taxpayer's trade or business. Meals or entertainment for which the taxpayer fails to show a clear business connection are deemed personal (nondeductible) expenses.Distinguishing "Directly Related" and "Associated-With" Entertainment
Business meals or entertainment activities can occur before, during, or after the related business event (i.e., business meeting, discussion, negotiation, etc.). Thus, these business expenses are deductible if they qualify under either of the following tests:
- "Directly related" entertainment: The business event and the entertainment activity occur simultaneously.
- "Associated-with" entertainment: The entertainment activity precedes or follows the business discussion.
Under the business connection requirement, meal or entertainment expenses are not deductible unless the taxpayer establishes that the item was directly related to the active conduct of the taxpayer's business, or in the case of an item directly preceding or following a substantial and bona fide business discussion, that the item was associated with the active conduct of the taxpayer's business. It is often more difficult to prove a business connection for directly related entertainment than for associated-with entertainment.
A meal or entertainment activity that occurs while business is being conducted (i.e., a combined entertainment-business event) must meet the following requirements to be deductible as directly related entertainment (Regs. Sec. 1.274-2(c)(3)):
- Main purpose: The primary purpose of the combined entertainment-business event is the active conduct of the taxpayer's trade or business. It is not necessary that more time be devoted to business than to entertainment to meet this requirement. However, business discussion that is only incidental to the entertainment does not satisfy this requirement.
- Active business: The taxpayer actively engages in a business meeting, discussion, negotiation, or other bona fide business transactions during the entertainment period.
- Profit expectation: The taxpayer had more than a general expectation of getting income or some other specific business benefit from conducting the business discussion (other than the goodwill of the person or persons with whom the discussion occurred).
Proving a business connection for directly related entertainment is difficult because the meal or entertainment is commingled with the business. The taxpayer must show that a valid business event took place in an entertainment setting. It becomes necessary to maximize the importance of the business event and minimize the enjoyment from the entertainment.
Example 1. Directly related entertainment: E, a business customer, flies in from out of town to talk business with F. The two discuss business over a meal. To show a business connection, F must prove that (1) the primary purpose of the combined business-entertainment event was the active conduct of business; (2) he actively engaged in a business meeting or discussion; and (3) he had a profit expectation—more than simply business goodwill.
Note: Even small amounts of significant business discussion can go a long way toward proving the primary purpose of the entertainment activity was business. Taxpayers should be encouraged to make a clear and concise record of the meeting's purpose, particularly when the amount of time spent in business discussion is small in relation to the time spent entertaining. Simply noting "to improve business" or "business discussion or meeting" is not enough.
Example 2. Proving a business purpose for directly related entertainment:F meets with three business associates at a country club for a round of golf to discuss a business deal on a significant real estate property. After 20 minutes of intense business discussions while completing the first two holes, a deal is struck. The golf game wraps up three hours later.
The amount of time spent on business is clearly much less than that on entertainment. However, the critical nature of the business discussion can go a long way toward proving a business purpose. To support a business purpose for the golfing event, F's written record should highlight the importance of the business discussion and its possible impact on his business.
The taxpayer also must have more than a general expectation of getting income or some other specific business benefit—other than the goodwill of the person or persons entertained (Regs. Sec. 1.274-2(c)(3)(i)). However, it is not necessary that the taxpayer actually close on a deal.
Example 3. Taxpayer must expect a specific business benefit: F takes a business client to lunch. The two talk about business in general but fail to discuss the specifics of any possible business arrangement. The IRS may assert this is simply a goodwill meal for which F did not expect a specific business benefit. If so, F will fail to show a business connection under the directly related test.
The setting or location of the combined entertainment-business event is of critical importance for deductibility. See below for how setting or location impacts the deductibility of directly related entertainment. See also below for how to keep goodwill meals or entertainment deductible by meeting the associated-with requirement.
A meal or entertainment activity that directly precedes or follows a business discussion, meeting, negotiation, etc., must meet the following requirements to be deductible as associated-with entertainment (Regs. Sec. 1.274-2(d)):
- Associated with taxpayer's business: The meal or entertainment is associated with the active conduct of the taxpayer's business. Generally, any ordinary and necessary expense is associated with the active conduct of the taxpayer's business if the taxpayer can prove a clear business purpose for incurring the entertainment expense. Generating business goodwill (i.e., to get new business or to encourage the continuation of an existing business relationship) is considered a clear business purpose (Regs. Sec. 1.274-2(d)(2)).
- Substantial business discussion: The entertainment must "directly" precede or follow a substantial business discussion. A business discussion is considered to be substantial only if the following apply (Regs. Sec. 1.274-2(d)(3)(i)):
- The primary purpose of the combined entertainment and business activity was the active conduct of the taxpayer's trade or business. It is not necessary that more time be devoted to business than to entertainment to meet this requirement. However, business discussion that is only incidental to the entertainment does not satisfy this requirement.
- The taxpayer actively engaged in a business meeting, discussion, negotiation, or other bona fide business transaction.
- The taxpayer had more than a general expectation of getting income or some other specific business benefit from conducting the business discussion (other than the goodwill of the person or persons with whom the discussion occurred).
Note: These three requirements apply only to the business discussion. The entertainment that precedes or follows the business discussion is subject only to the much less rigorous "clear business purpose" requirement.
Entertainment that occurs on the same day as the substantial business discussion is considered to directly precede or follow the discussion. If the entertainment and business discussion do not occur on the same day, the taxpayer must consider the facts and circumstances to see if the entertainment precedes or follows the business discussion. Among the factors to consider are the date, place, and duration of the business discussion. If either party is from out of town, consideration should also be given to dates of arrival and departure, and the reasons the entertainment and discussion did not take place on the same day. If the entertainment of out-of-town business associates occurs on the evening before, or on the evening of the day following, the business discussion will generally be regarded as directly preceding or following the discussion (Regs. Sec. 1.274-2(d)(3)(ii)).
Example 4. Associated-with entertainment: E, a business customer flies in the night before a business meeting. F entertains the business customer the evening before the business meeting and on the day after the business meeting. This is associated-with entertainment. To be deductible, F must establish a clear business purpose (such as goodwill) for the entertainment and prove that it directly preceded or followed a substantial business discussion.
Note: The associated-with requirement is much less stringent than the directly related entertainment requirement. The taxpayer need only prove that a valid business event (discussion, negotiation, meeting, etc.) occurred before or after the entertainment activity. If so, the taxpayer and the guest can fully enjoy the meal or entertainment activity. Because the business event is evaluated separately from the entertainment activity, there is no pressure on the taxpayer to minimize the pleasure associated with the entertainment activity. That is a much easier standard to meet than for directly related entertainment.Location or Setting Is Key for Directly Related Entertainment
When the meal or entertainment activity occurs simultaneously with the business event (i.e., directly related entertainment), the setting or location becomes critical. Meals or entertainment occurring in a clear business setting or a setting conducive to business (such as a luncheon or dinner club) will meet the directly related requirement if a valid business discussion, meeting, etc., occurs. Meals or entertainment occurring in "suspect" settings likely will not.
If the entertainment occurs in a clear business setting, it meets the directly related test. For this purpose, a clear business setting includes a hospitality room or convention where a taxpayer creates business goodwill through the display or discussion of business products. It also includes entertainment that is mainly a price rebate on the sale of the taxpayer's products (e.g., a restaurant owner providing an occasional free meal to a loyal customer), or entertainment of a clear business nature occurring under circumstances where no meaningful personal or social relationship exists between the taxpayer and the persons entertained (e.g., entertainment of civic or business leaders at an open house) (Regs. Sec. 1.274-2(c)(4)).
Example 5. Clear business setting: A retail merchant opens a new branch retail store. The merchant invites local city officials to the grand opening and serves refreshments to the public. The entertainment activities occur in a clear business setting and meet the directly related requirement.
Luncheon or dinner clubs provide an atmosphere that is conducive to business meetings, discussions, negotiations, etc. Thus, it is relatively easy to satisfy the directly related requirement for meals taken at a luncheon or dinner club—provided the taxpayer proves the meal occurred during an active business discussion.
Example 6. Business meeting at dinner club: F regularly takes business associates to dinner at a local dinner club. If F properly documents that (1) the primary purpose of the meal was business, (2) a valid business discussion or negotiation took place during the meal, and (3) he had a specific profit expectation, the cost of the meal will meet the directly related requirement.
Meal or entertainment expenses may not be deductible under the directly related criteria if they occur in settings or locations where, because of substantial distractions, there is little or no possibility of engaging in the active conduct of business, or the primary purpose is not considered to be business. This includes the following:
- Meetings or discussions held at nightclubs, theaters, and sporting events, or during essentially social gatherings such as cocktail parties (Regs. Sec. 1.274-2(c)(7)(ii)(a));
- Meetings or discussions held at places such as cocktail lounges, country clubs, golf and athletic clubs, or vacation resorts, if the taxpayer meets with a group of persons that includes nonbusiness associates (Regs. Sec. 1.274-2(c)(7)(ii)(b)); and
- Meetings or discussions held on hunting or fishing trips, or on yachts and other pleasure boats (Regs. Sec. 1.274-2(c)(3)(iii)).
In the preceding three instances, the presumption is that the entertainment is not directly related to the active conduct of the employer's business (the first and second items), or the primary purpose of the entertainment is personal, not business (the third item). While the employee can refute this presumption and prove the entertainment is directly related or has a primary business purpose by showing a substantial business meeting or discussion was held during the entertainment activity, the burden of proof is on the taxpayer (Regs. Secs. 1.274-2(c)(3)(iii) and (c)(7)).
Example 7. "Tainted" setting spoils deduction for directly related entertainment: F routinely takes many of his clients and customers to local professional sporting events. Some business discussion occurs during the sporting events, but no business discussion precedes or follows the sporting event (thus, the associated-with requirement is not met).
A taxpayer generally does not meet the directly related test when the location of the combined business discussion-entertainment is a sporting event. Here, it is presumed there is little or no possibility of engaging in the active conduct of the taxpayer's business. While F may overcome this presumption, it is difficult to do so. Thus, it is likely the expenses incurred for the entertainment at the local sporting events are nondeductible.
Example 8. Presence of nonbusiness associates taints business connection:F maintains a membership at the local country club. He often invites business associates and prospective clients to the club for lunch and an afternoon round of golf, during which business is often discussed. Sometimes personal friends or other nonbusiness associates may join in during lunch and for the afternoon golf game. No business discussion occurs before or after these country club outings.
The directly related test will likely be met in those instances where the golf outings involve only business associates. For these outings, the setting, in and of itself, will not cause the entertainment activity to fail the directly related test. If F can prove a valid business discussion occurred and otherwise satisfy the directly related requirements, the golf outing expenses will be deductible business expenses.
The directly related test will likely not be met in those instances where the country club outings also involve nonbusiness associates. For these outings, the setting, combined with the presence of nonbusiness associates, likely causes the entertainment activity to fail the directly related test. The presumption is there was little or no possibility of engaging in the active conduct of the taxpayer's business during the entertainment event. While F may be able to overcome this presumption, it may be difficult to do so.
Note: Taxpayers that routinely incur meals or entertainment expenses at suspect locations or settings should be encouraged to conduct a bona fide business discussion at the office, at a luncheon or dinner club, or in some other obvious business setting before or after the meal or entertainment. In this way, the taxpayer may use the associated-with requirement to convert meal or entertainment costs into deductible business expenses. See the following discussion for more on this planning strategy.Keeping Business "Goodwill" Meals and Entertainment Deductible
Entertainment that directly precedes or follows a substantial business discussion may occur in any setting or location without hindering the "business" aspect of the business discussion. Thus, if the business discussion is held in a setting that is conducive to business (i.e., in a setting other than the suspect settings described above), the entertainment, meal, or activity may occur anywhere (even at those suspect settings) and still satisfy the clear business purpose requirement associated with the test. Here, the cost of the goodwill entertainment is a deductible business expense.
Note: Taxpayers who incur business goodwill meals or entertainment should be encouraged to conduct a bona fide business discussion before or after the business meal or entertainment. In this way, the taxpayer may use the associated-with requirement to convert meal or entertainment costs for business goodwill into deductible business expenses.
Example 9. How to keep "goodwill" entertainment deductible: F frequently incurs meal expenses by entertaining lunch and dinner guests. Some of the entertaining involves bona fide business discussions with existing and potential clients and with professional advisers such as bankers, accountants, and attorneys. Some of the entertaining is done on a friendship or goodwill basis with longtime clients and business associates and does not involve business discussions.
Meal expenses incurred by F in the first situation are deductible as business expenses because they meet the directly related requirement for deductibility (assuming he properly substantiates the expenses). The business goodwill meal expenses in the second situation do not meet the "directly related" test because no business is discussed or conducted during the meals. F is not entitled to a business deduction for these amounts.
Note: F may be able to convert the expenses discussed in the second situation (i.e., those that fail the directly related test) into deductible business expenses that satisfy the associated-with test by arranging for a substantial business discussion to directly precede or follow the business meal. If this is done, then there is no need to actively discuss business during the meal since all that is required, under the associated-with test for the entertainment activity, is that a clear business purpose exists for incurring the entertainment cost. Incurring meal costs to generate business goodwill meets this clear business purpose requirement.
This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 17th edition (March 2016), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).