Deductions for entertainment expenses are often lost because of failure to satisfy a technical rule or substantiation requirement, Deloitte, Haskins & Sells, the accounting firm, reports. A review of the basic rules may help maximize deductions and avoid costly penalties.
Taxpayers whose business or investment activity requires them to entertain are eligible for this deduction.
Expenses for business and income-producing entertainment must meet strict tests to be deductible. For these purposes, entertainment includes going to restaurants, nightclubs, theaters, and sporting events; taking hunting and fishing trips; and providing food, lodging, and transportation. The expenses must be:
* Ordinary and necessary.
* ''Directly related to'' or ''associated with'' the active content of business or production of income.
* Substantiated by adequate records.
Ordinary and necessary expenses. Entertainment that is customary and usual within the experience of a particular trade, industry, or business is considered ordinary and necessary. An expenditure for entertainment that is lavish or extravagant will be disallowed.
Usually, an entertainment expense must also meet either the ''directly related'' or ''associated with'' test to qualify for deduction.
Directly related entertainment expenses. These take place in a business setting and the taxpayer (1) at the time the expenditure was made has more than a general expectation of receiving income or benefit (other than merely goodwill) from the expenditure; (2) was actively engaged in the conduct of business during the entertainment; and (3) had as the principal purpose of the combined business and entertainment activity the active conduct of business. An example would be the expenses of a hospitality suite at a convention.
Expenses that are not directly related to but are associated with the active conduct of business will be allowed if the taxpayer establishes a clear business purpose in making the expenditure (obtaining new business, for example), and the entertainment directly precedes or follows a substantial and bona fide business discussion. An example would be a lengthy business meeting followed by dinner and the theater with spouses.
To meet this second requirement, you must demonstrate that you actively engaged in a business meeting for the purpose of obtaining income, and that such a meeting was substantial in relation to the entertainment. But it is not necessary that more time be devoted to business than entertainment.
Entertainment facilities. No deduction is allowed for expenses of an entertainment facility (such as a yacht or hunting lodge). But this absolute prohibition does not apply to dues of clubs or professional or business associations.
Substantiation. Generally, no deduction will be allowed for any expenditure for entertainment unless you substantiate, with detailed records, the following elements of each expenditure:
-- Time, place, type of expense. Date, address or location, designation of type of entertainment (such as dinner).
-- Business purpose. Reason for entertainment, nature and duration of business discussion or activity.
-- Business relationship. Names of individuals entertained or other designation sufficient to establish business relationship.