The holiday season is just around the corner—a time when many of us enjoy more occasions involving food, drink, and, if we’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 doesn’t quite see it the same way, so it’s important to know the tax rules related to travel and entertainment (T&E) expenses.
Remember, not all T&E expenses are created equal.
The first thing to chew on when it comes to T&E expenses is that 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 keep in mind that the IRS accepts deductions for T&E expenses only when they are not considered “lavish or extravagant” which is usually determined by 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 only deductible (1) when you are traveling away from home for business-related purposes and (2) when the meal or activity constitutes business-related entertainment. While you may be tempted to throw a few receipts from personal holiday meals into your business expense file, this is not an advisable—or legal—practice. 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 having a favorable meeting with a client or associate. Generally, “meetings” taking 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.
While this rule might seem stringent, it is important to note that you do not have to discuss business during the meal or social gathering, but a “substantial business discussion” does need to take place on the same day, unless you or your client travel from out of town, then you can still 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 if it does not have sufficient documentation. 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. Any amount paid in excess of $75 or more requires a receipt or other physical document as proof.
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Mixing business and pleasure doesn’t lower your taxable income.
If you decide to mix business and pleasure and visit a client while also enjoying some personal time after you get there, 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) but no personal entertainment or meal expenses can be deducted. If you attend a convention or seminar that you travel to, it is likely that the IRS will scrutinize the nature of the meetings to determine if they are disguised vacations.
Bring the family on a business trip, but don’t deduct their expenses.
When it comes to having family accompany you on a business trip, the IRS does not allow any deductions for travel or other related expenses for family members unless they are traveling with you as employees of your business and are necessary to the business purpose of your trip. A necessary business purpose does not generally include 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 and these activities are often heightened over the holidays. As such, it is essential to track and document all legitimate T&E expenses and to be clear about which ones are fully deductible, which ones are partially deductible, and which ones are not deductible at all. Remember, overstating T&E expenses may raise a red flag for an IRS audit, so be sure to only deduct legitimate business expenses and seek the assistance of a tax professional to ensure that you are calculating and reporting them correctly on your tax return.
Jonathan Medows is a New York City based CPA who specializes in taxes and business issues for consultants across the country. His website, www.cpaforfreelancers.com, has a resource section with how-to articles and information for freelancers.