Most business owners know that certain entertainment expenses are deductible under some circumstances, but judging by the large number of questions I get on this topic, I don´t think many people actually know the rules.
Like all business deductions, entertainment costs must be "ordinary and necessary" in order to qualify. If your business is a used furniture shop, it´s not very likely that the cost of taking one of your customers to dinner and a movie would be an ordinary and necessary business expense. On the other hand, it could be, if for example the customer you take out for the evening is furnishing a motel and is prepared to spend $45,000 on furniture.
The dictionary definition of entertainment is "something that amuses, pleases, or diverts," activities that are pleasant, fun; in other words, entertainment is the opposite of job, labor, work. Congress and the IRS, along with most people in general, associate doing business with work — the opposite of entertainment. Therefore, in order for a business owner to convince IRS that she was having fun and working at the same time, the business owner has to satisfy a high standard of documentation (never mind that there are times when taking certain customers out to dinner is one of the very last things a business owner would choose to do for pleasure).
Sara is a financial planner who specializes in retirement planning for employees of small businesses. Emily owns a janitorial service that has 12 employees. For months Sara has been trying to get an appointment with Emily to show her how setting up a flex plan for her employees would make good financial sense for both the business and the employees, but Emily never has time. Finally, Sara says, "You have to eat lunch anyway. Why don´t you let me take you to your favorite restaurant, and we can talk about employee benefits over lunch."
Here is the information Sara needs to record in order for the cost of taking Emily to lunch to qualify as a deductible business expense:
1. The location — Mavis´s Downtown Country Cooking
2. Names of people entertained — Emily (in "real life" you would want to include the person´s last name), owner Clean as a Whistle
3. Date — November 8, 2006
4. Business purpose — Discuss flex plan with business owner
5. Amount spent — $35
Treasury Regulations state that this information must be recorded in a timely manner — in other words, you should record the information soon after the entertainment event rather than waiting until the day before an IRS audit.
The location, date, and amount spent are already on the receipt Sara gets from the restaurant, so all Sara needs to do is write Emily´s name and the business purpose somewhere on the receipt and make sure the receipt is properly filed.
Mavis´s Downtown Country Cooking is 7.5 miles from Sara´s office, so Sara also had a mileage deduction to record in connection with taking Emily to lunch. Some business owners find it convenient to keep a record of both entertainment costs and mileage in their appointment calendars. IRS auditors like to be able to cross check mileage and entertainment records against an appointment calendar or organizer. They are trained to look for inconsistencies, such as a receipt from McCormick & Schmick´s, November 8, 2006 claimed as a business entertainment expense "J. Smith — discussed potential referrals" and an entry on the calendar for November 8, 2006 that reads, "Sally´s birthday — McCormick & Schmick´s 7:30"
To be continued