Making Travel Less Taxing: Introduction
Your Tax Home (Away from Home)
Airfare and Transportation
Lodging and Meals
Entertaining Clients
Car Expenses
The Nitty Gritty: Required Receipts and Tax Forms
Ask Scott!
It’s Tuesday which means it’s time for another journey into taxes and travel! One of the biggest potential political footballs for any business in the public eye is entertainment costs. Whether rewarding its own employees or wooing potential customers, corporate spending for lavish entertainment is fodder for unflattering attention from the media, or worse, Congress and the IRS.
Following the financial bailouts in 2008, staid financial institutional Northern Trust achieved a first in its 120 year history: they made TMZ! After receiving TARP funds, the bank feted clients attending the Northern Trust Open golf tournament in Los Angeles with an elaborate weekend featuring concerts by Chicago, Sheryl Crow, and Earth, Wind and Fire, lodging at the Ritz Carlton and Beverly Wilshire and gift bags from Tiffany & Co. This type of corporate entertainment is of course quite common, but the bailout funds made them newsworthy and put a brief spotlight on this area of tax law. How much of these costs were deductible? Let’s examine the rules for entertainment and gifts to find out.
The majority of taxpayers, of course, are out of the public eye, but the same rules apply to all businesses and asking “how could I defend this to the IRS?” is perhaps especially helpful in this area where the law is less precise. Like airfare, lodging and meals, entertainment expenses must be ordinary and necessary in your trade or business and be unreimbursed to be deductible. Unlike airfare, lodging and meals, though, your tax home is not relevant to determining whether these expenses are deductible. Employers or self-employed individuals will deduct these costs directly against income, while an employee will deduct them as an unreimbursed business expense only after exceeding a 2% threshold for miscellaneous itemized deductions.
Two Tests: Directly Related or Associated With
Entertainment expenses are deductible if they are either directly related to or associated with the active conduct of a trade or business. Words have meaning, especially when used in tax law; so, what do these rather innocuous words mean?
Directly Related
To show that the entertainment was directly related to your business, you must show all of the following:
- The main purpose of the business and entertainment event was the active conduct of business;
- You actually engaged in business with the person during the entertainment event; and
- You had more than a general expectation of getting income or other business benefit at some future time.
Obviously, these rather broad parameters leave a great deal of discretion to the taxpayer. The IRS has singled out hunting and fishing trips and yachting as activities that are generally not likely to pass the directly-related test but states that all the facts of each situation must also be considered. The Service also identifies meetings at a nightclub or sporting event as prone to creating distractions that would prevent you from actively conducting business.
Hunting trips like former Vice President Cheney enjoys are generally not considered to meet the directly-related test, but what about the cost of driving to visit your hunting partner in the hospital? I’ll cover that next week.
Associated With
If your expenses do not meet the directly-related test, they may still be deductible if they are associated with the active conduct of business and occur directly before or after a substantial business discussion. If the purpose of an expense is to obtain new business or deepen an existing business relationship, then the “associated with” prong is met. The IRS unhelpfully states that a substantial business discussion “depends on the facts of each case,” while adding that it’s not necessary that the time spent on business exceed the time spent entertaining for the test to be met. Thus, the associated with test is less stringent than the directly related to test and does not expressly forbid deductions for sporting event tickets and other revelry.
Airline and Other Clubs
One could easily see how membership in an airline club could be conducive to meeting the directly related to or associated with test. After all, throwing a game of billiards to bolster your client’s ego might be just the right touch to close a sales contract.
The Turkish Business Class lounge in Istanbul has a library and billiards room under one of its many arches.
Unfortunately, the IRS has specifically listed club dues and membership fees as not meeting either the directly related to or associated with tests, citing their purpose as being aimed at social rather than business pursuits. Apparently, the Service does not appreciate how seriously some frequent travelers take your lounge access. Country clubs, golf and athletic clubs, and airline and hotel clubs are among the list of nondeductible memberships. Of course, if your airline club admission is obtained through tax-deductible airfare expenditures, then in theory, the airline club admission was in fact deductible since you obtained it as part of your airfare expense, and you found a way around the Service’s rules—well done. 🙂
Luxury Boxes
Attending a major sporting event or concert at a venue with luxury boxes is a boondoggle frequent business development tool, and the IRS has special rules for such events. If you rent a skybox for more than one event, then you can generally only deduct the price of a non-luxury box seat ticket times the number of seats in the box, not the actual cost of the box. So, if a 20 person suite costs $20,000 per game, but the highest seat not in a box (unboxed seat?) is $100, then your maximum entertainment deduction would be $2,000, not $20,000 (subject to the 50% limitation). Also note that food and beverages are deductible in addition to the skybox rental amount subject to the limits discussed in last week’s blog entry.
Over time, sellers of luxury box tickets have figured out how to maximize their sales by increasing the price of non-box seats to make more of the skybox rental fees deductible to skybox customers. As the price of these premium seats has gone up, the “lost” deduction of having the luxury box deduction tied to the amount of non-box seats has fallen. For example, upon opening the new Yankees Stadium, the team purportedly charged home plate ticket prices between $500 to $2,500, and the upcoming April Fool’s Day contest against the Red Sox shows a home plate ticket for sale for $2,487. So, in that case, if a business wanted to rent out a suite for 20 people, as long as they could find a suite to rent for $50,000 ($2,500 times 20) or less, all of the cost would be deductible. Presumably, the IRS has failed to update their regulations in this area to keep apace of changing ticket pricing practices because other regulatory efforts offer more potential revenue.
Citing the Yankees, two sports-hating thoughtful professors discuss the effect of the deductibility of luxury boxes on average ticket prices, terming the entertainment expense deduction as a “skybox tax subsidy” in a New York Times editorial. For the same professors’ lengthier argument on why the deduction for entertainment expenses should be eliminated, see this tax note.
Those front row seats at the new Yankee Stadium serve as a “limit” for what may be deducted for a suite rental.
Client Gifts
Gifts are deductible up to $25 per client, which may explain the plethora of chocolate box gift sets priced near that figure at wholesale and office supply stores during the holiday season. Note that the gift limit is not subject to the fifty percent limit applicable to entertainment costs. If you attend an event with a client, you must treat it as an entertainment cost, even if doing so results in a lower tax deduction than the $25 gift amount would permit. But, if you gift tickets to a client and do not attend the event, you may choose to classify the ticket as either an entertainment expense or client gift based on which method gives you a higher deduction. Of course, if a “gift” is simply a part of providing accommodations, then it’s not subject to the $25 limit.
A “gift” like what Lucky received from Brussels Airlines is not subject to the $25 gift limit because such items are considered part of the airline’s product delivery.
Conclusion and Next Time
I hope this week’s discussion of entertainment costs was…entertaining. Although I have no personal knowledge of what Northern Trust actually deducted for its client outing, a case could easily be made that all of the costs passed the associated with test, making all of the expenses deductible less the fifty percent limitation (save the gift bags which are subject to a $25 per client limit).
Entertainment costs are a great way to obtain new business or reward high performers but can also bring unwanted publicity. These expenses must be directly related to or associated with the active conduct of a business, and only half of the costs are deductible. Client gifts are deductible in full but are limited to $25 per client. Next week, I’ll discuss car expenses for those times when you drive instead of fly. Please leave any questions you have in the comments or feel free to contact me on my law firm website or follow me on Twitter @ScottTaxLaw.
Disclaimer: While I hope the information I provide will be helpful (and hopefully even humorous at times), none of this information should be construed as offering legal advice or creating an attorney-client relationship between the reader and my law firm. You should not act or refrain from acting based on this advice and should consult your own attorney or CPA regarding your specific tax matters. IRS Circular 230 Notice: Nothing in these communication is intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
Gary -
Yes, as long as the use of the club by the employee is 100% for business-use, then what you have said in comment 4 comports with the example in the Regulations that I linked to in comment 3. I haven't seen a PLR on this specifically, but the Reg can be cited as authority whereas a PLR cannot, as you likely know.
It's been 8 or 9 years since I looked at this but I recall reading either an IRS publication or private letter ruling discussing airline club memberships specifically and concluding that as long as the business use membership was provided to the employee and the expense not taken as a deduction by the employer that it would not be taxable to the employee. Haven't had time to search for this.
Gary -
Here's an example from the Regulations on taxable fringe benefits that is also helpful in answering your question (and seems to be a more fuller explanation to the IRS's own publication I cited above). If the employee can demonstrate a business-use percentage for the membership, then that amount is a non-taxable fringe benefit. The amount allocable to personal-use, if reimbursed by the employer, will be taxable to the employee, though. Regardless of business-use...
Gary -
Here's an example from the Regulations on taxable fringe benefits that is also helpful in answering your question (and seems to be a more fuller explanation to the IRS's own publication I cited above). If the employee can demonstrate a business-use percentage for the membership, then that amount is a non-taxable fringe benefit. The amount allocable to personal-use, if reimbursed by the employer, will be taxable to the employee, though. Regardless of business-use by the employee, the club dues will be non-deductible to the employer as I mentioned.
Example 1. Assume that Company X provides Employee B with a country club membership for which it paid $20,000. B substantiates, within the meaning of paragraph (c) of this section, that the club was used 40 percent for business purposes. The business use of the club (40 percent) may be considered a working condition fringe benefit, notwithstanding that the employer's deduction for the dues allocable to the business use is disallowed by section 274(a)(3), if X does not treat the club membership as compensation under section 274(e)(2). Thus, B may exclude from gross income $8,000 (40 percent of the club dues, which reflects B's business use). X must report $12,000 as wages subject to withholding and payment of employment taxes (60 percent of the value of the club dues, which reflects B's personal use). B must include $12,000 in gross income. X may deduct as compensation the amount it paid for the club dues which reflects B's personal use provided the amount satisfies the other requirements for a salary or compensation deduction under section 162.
Treasury Regulation §1.132-5(s)(3).
http://www.taxalmanac.org/index.php/Treasury_Regulations,_Subchapter_A,_Sec._1.132-5
Gary -
I know of no prohibition against the employer deducting the annual fee of a business credit card provided to an employee, so I think that would be deductible to the employer and non-taxable to the employee.
Regarding your first question, I think it's a closer call.
The IRS publication on Taxable Fringe Benefits (http://www.irs.gov/pub/irs-tege/fringe_benefit_fslg.pdf) on pages 69-70 points to club dues as a taxable fringe benefit citing IRC 274(a)(3).
Based on...
Gary -
I know of no prohibition against the employer deducting the annual fee of a business credit card provided to an employee, so I think that would be deductible to the employer and non-taxable to the employee.
Regarding your first question, I think it's a closer call.
The IRS publication on Taxable Fringe Benefits (http://www.irs.gov/pub/irs-tege/fringe_benefit_fslg.pdf) on pages 69-70 points to club dues as a taxable fringe benefit citing IRC 274(a)(3).
Based on that publication and Code Section, I'd say that the airline club membership is taxable to the employee if paid by the employer. I suppose the taxpayer argument could be that an airline lounge is not an entertainment or recreational organization but is instead a business or professional organization, but I think that's tenuous.
Let me look at the Regulations of Code Section 274 to see if anything is more definitive.
"Unfortunately, the IRS has specifically listed club dues and membership fees as not meeting either the directly related to or associated with tests, citing their purpose as being aimed at social rather than business pursuits. Apparently, the Service does not appreciate how seriously some frequent travelers take your lounge access. Country clubs, golf and athletic clubs, and airline and hotel clubs are among the list of nondeductible memberships."
This is only half right, I think.
..."Unfortunately, the IRS has specifically listed club dues and membership fees as not meeting either the directly related to or associated with tests, citing their purpose as being aimed at social rather than business pursuits. Apparently, the Service does not appreciate how seriously some frequent travelers take your lounge access. Country clubs, golf and athletic clubs, and airline and hotel clubs are among the list of nondeductible memberships."
This is only half right, I think.
1. While not deductible to a business, a business could provide a club membership to an employee and that airline lounge membership would not be a taxable fringe benefit.
2. A company can pay the annual fee for a business credit card, and if such card provides airline lounge access that access would not be a taxable fringe benefit.
So while an airline lounge membership itself might not be generally deductible, neither is it necessarily taxed.
Am I mistaken?