This one is a big problem for business owners, self-employed individuals, and even employees who are not required to submit expense reports.
First, of course, you have to know what "entertainment" and "meals" are, in the context of the Tax Code. Generally speaking, if you engage in an activity just for fun or enjoyment with another person or persons, that´s Entertainment. Examples would be taking a prospective customer to a ball game or concert, or taking a client on a sight-seeing tour of your city.
If a real estate agent takes a client on a tour of a neighborhood where the client is considering purchasing a home, that´s not entertainment, because it´s part of getting the job done, it´s not just for fun. If you take a prospective client to lunch as a means of introducing yourself and your company, that´s a Meal. Stocking your employee break room with sodas and bottled water does not result in a Meal expense — the water and sodas would most likely be entered on your books as supplies.
Some items could fit into more than one category — for example, if you send a client a coupon for dinner at a restaurant, this could be considered a Meal or a Gift . For items like this that could go either way, you´d want to see which classification would result in the greater deduction, keeping in mind that the business gift deduction is limited to $25, and the deduction for meals is only 50% deductible in most cases.
Once you´ve determined that you have a meal or entertainment expense, you need to get past a couple of hurdles before you can actually take the deduction:
1. Is it ordinary and necessary for your kind of business? If you manufacture containers and you want to sell boxes to Hold-It-Tite, a company that makes fasteners sold in do-it-yourself building supply stores, it would not be out of line for you to invite Hold-It-Tite´s president and her husband to dinner. On the other hand, if a clerk in a do-it-yourself building supply store takes a customer of the store to lunch, this probably will not qualify as ordinary and necessary from the point of view of the clerk (it might be a legitimate expense from the store owner´s point of view, if the customer is a contractor who spends thousands of dollars a week at the building supply store).
2. Is the entertainment or meal expense "directly related to" or "associated with" your business? The reason for making the distinction is that the documentation requirements differ slightly, depending on which category fits. For example, you pick up an out-of-town client at the airport and he mentions he hasn´t had anything to eat since breakfast; so instead of taking him directly to the hotel where he´ll be staying, you stop at a restaurant on the way. Your conversation with the client never strays far from the business that has brought the client to town — that´s Directly Related. If you take a customer to a ball game and talk business in the car on the way to the game, that´s Associated With.
Your record-keeping requirements are more stringent if the meal or entertainment is Associated With your business rather than Directly Related. The reason is that for expenses that are Associate With, you are required to have business discussion either before or after, or at least on the same day as, the fun stuff. In addition to the date and name of the person you entertained, you´ll want to make a note of what you discussed and when the discussion took place. Your notes can be brief, but there must be enough there to be meaningful. For example, "Lunch Jill Smith, business discussion" is probably not enough, but "Lunch Jill Smith, Hold-It-Tite account," probably is.
You may wonder why I keep saying "probably" instead of just stating that an expense either will or will not qualify. This is because entertainment and meal expenses are evaluated through the use of a "facts and circumstances" test. In other words, there isn´t any objective bright-line test. For someone who did great on essay tests in school, this is a good thing. For someone who preferred True-False questions, it can be very frustrating.
You can keep your records for entertainment and meal expenses in your calendar or in a special log book, or you can jot the information down on the back of the invoice or restaurant check. The best of all possible record keeping would include a log, backed up by your calendar and an invoice or check, and proof of payment in the form of a credit card bill or bank statement.
Personally, I like to carry a small accordian file around in my car. It has a flap that fastens down with velcro and a handle, so it can be carried like a briefcase. Whenever I get a receipt, I write the required info on the back (usually takes about 30 seconds) and put it behind the appropriate tab in the file (2 seconds). Let’s say I save $6.60 in taxes from a deduction for a business meal. Filing the receipt has consumed around 32 seconds of my time — $6.60 for 32 seconds — that’s around $792 per hour. I don’t know about you, but I consider that a pretty decent rate of return on my time.