The holiday season is here (in case you hadn't noticed!), which means time for awkward get-togethers with your in-laws and too much shopping on Amazon Prime. Actually, it means times for happy occasions involving food, drink, and, if you’re lucky, travel. For self-employed individuals, entertaining clients or traveling to their places of business can seem like a veritable feast of potential tax deductions. However, the IRS views that feast more like a famine. Thus, it’s important to know the tax rules related to travel and entertainment (T&E) expenses.
Not all T&E expenses are created equal.
Chew on this: while business-related travel costs are deductible on a dollar-for-dollar basis, expenses for meals and other forms of entertainment can only be deducted at a rate of 50 percent of their actual cost. So if you treat a client to a holiday lunch and the bill comes to $100, you can only deduct $50 from your taxable income. Also, T&E expenses must not be considered “lavish or extravagant” by the IRS. How can you tell if picking up the tab for your client’s tarte flambé at that trendy farm-to-table joint is “lavish or extravagant”? It is determined by a coin toss in the IRS office. Seriously, they use a reasonableness test. For example, if you have a client that generates $2,000 of billings a year for your business, taking a deduction for a $3,000 off-site “meeting” in an exotic location may raise some IRS auditors’ eyebrows.
Make sure your deductible expenses really are related to your business operations.
In general, expenses for travel, meals, and entertainment are deductible only if you had a really good time. Kidding. They are deductible only (1) when you are traveling away from home for business-related purposes and (2) when the meal or activity constitutes business-related entertainment. Thus, throwing a few receipts from personal holiday meals into your business expense file is not advisable—or legal. The IRS rules for T&E expenses specifically state that they may be deducted only when they are “directly related to” or “associated with” your business.
To pass the IRS “directly related” test you must have an “active” discussion with your client with the ultimate goal of achieving increased revenues, or some other specific benefit, not just general goodwill from a favorable meeting. Generally, “meetings” that take place at sporting events, night clubs, or cocktail parties— essentially social events— would not meet this test, unless there was a “substantial business discussion” that takes place before or after such an event.
You don’t have to discuss business during, say, that epic Ugly Christmas Sweater party, but a “substantial business discussion” does need to take place on the same day. However, if you or your client traveled from out of town, then you can deduct a meal or entertainment expense that is incurred the day before or after your business meeting.
Before you deduct any expenses, you must document them.
In general, all business travel costs related to time away from your business “tax home” (i.e. the city or area where your business is located) are deductible, if properly documented. Like other expenses, a deduction for travel expenses is not permitted without sufficient documentation. So keep your receipts! Documentation of both travel and entertainment expenses must include the amount spent, the time and place of the event, its business purpose, and the business relationship of the individuals involved. (Sounds as detailed as the list of reasons why you broke up with your last boyfriend!) Any amount paid in excess of $75 or more requires a receipt or other physical document as proof. Simply vouching “I totally paid that much, honest” does not count.
Mixing business and pleasure doesn’t lower your taxable income.
If you decide to mix business and pleasure when visiting a client and enjoy some personal time after you get there, then have a really good time. Just keep in mind that your travel costs (including any mileage, calculated at the standard IRS reimbursement rate) to and from the destination would be fully deductible (as long as you are actually visiting a client). However, your personal entertainment expenses, aka that trip to that new day spa and the facial you got there, cannot be deducted. If you travel to a convention or seminar, it is likely that the IRS will scrutinize the nature of the meeting to determine if it is really just a vacation in disguise.
Bring the family on a business trip, but don’t deduct their expenses.
If your family accompanies you on a business trip, whose bright idea was that? Never mind, enjoy all that togetherness. Note that the IRS does not allow any deductions for travel or other related expenses for family members. The exception is if they are traveling with you as employees of your business and are necessary to the business purpose of your trip. Sorry, little Susie’s attendance on the trip so she could visit the American Girl doll store near your client’s place of business is probably not deemed necessary. Neither is the participation of a spouse or partner in social functions even if they are a host or hostess.
Additionally, any incremental costs incurred because of a family member’s presence on your trip are considered non-deductible. So, if the cost of your hotel room is 15 percent higher because the extra person is staying with you, the incremental 15 percent charge is non-deductible; the other 85 percent would be a deductible business expense.
Be above board when it comes to T&E deductions.
Self-employed individuals often entertain clients or travel to meet them in the course of conducting their regular business, especially over the holidays. It is essential to track and document all legitimate T&E expenses and to be clear about which ones were the most fun—nope, which ones were fully deductible, partially deductible, or not deductible at all. Remember, overstating T&E expenses is like screaming, “Hey, look at me, I might be perfect for an IRS audit!” Therefore, be sure to only deduct legitimate business expenses and seek the assistance of a tax professional to ensure that you are calculating and reporting those expenses correctly on your tax return.
Jonathan Medows is a certified public accountant licensed in New York, New Jersey, Maryland, and Pennsylvania. He is also a recognized expert in taxation for freelancers and the self-employed—often tapped for his expert knowledge and perspective on self-employment taxation by national and regional publications such as The New York Post, BusinessWeek, Forbes taxation blog, WebCPA, CPA Practice Advisor, and others. You can read some of Jonathan’s press coverage here.
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