November 17, 2018

Planning for Tax Deductible Entertainment Expenses

Houston Tax Attorney Blog

Houston Tax Attorney

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Entertainment expenses are deductible but the deduction is limited to 50 percent of the amount spent. There have been a number of disputes between taxpayers and the IRS as to what counts as a limited entertainment expense.

The law was recently changed such that entertainment expenses are no longer deductible.  This change to full disallowance ups the stakes in determining what costs are entertainment expenses.  The recent Duncan v. Commissioner, T.C. Memo. 2018-190, provides an opportunity to consider these this in light of the distinction between entertainment and advertising expenses.

The Facts & Procedural History

The taxpayer is a workers compensation attorney.  Like many attorneys, he did not advertise his services.  His clients came from referrals, etc.

The taxpayer underwent significant brain surgery.  Prior to the surgery, he rented a yacht to host an event with his current clients.  It included a catered dinner, drinks, and entertainment, for the purpose of discussing with the clients the status of their cases, his upcoming surgery, and his expected availability following the surgery.

The total cost for the event was $8,284, consisting of $4,076 for yacht rental and related expenses, $3,200 for catering and entertainment, and $1,008 for a service charge and sales tax.

The taxpayer claimed $4,421 as an advertising expense deduction for the yacht event.  The IRS pulled the taxpayer’s return for audit.  The IRS disallowed the expense as an advertising expense, classified it as an entertainment expense, and applied the 50 percent limitation on entertainment expenses.

The question for the court was whether the expense was an advertising expense not limited by 50 percent or an entertainment expense.  We’ll start by considering the rules before the changes made by the Tax Cuts & Jobs Act (“TCJA”).

Pre-TJCA Entertainment Expenses

The general rule is that taxpayers are able to deduct ordinary and necessary business expenses that are actually incurred.  Entertainment expenses were deductible prior to the TCJA if certain substantiation requirements were met.  The deduction was limited to 50 percent of the amount incurred.

But what exactly is an “entertainment expense?”  The regulations provide the answer.  The term “entertainment” is defined in the regulations as:

[A]ny activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at night clubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family. The term “entertainment” may include an activity, the cost of which is claimed as a business expense by the taxpayer, which satisfies the personal, living, or family needs of any individual, such as providing food and beverages, a hotel suite, or an automobile to a business customer or his family.

The regulations provide for an objective test in distinguishing between entertainment and other expenses, such as advertising expenses:

An objective test shall be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally considered to be entertainment, it will constitute entertainment … regardless of whether the expenditure can also be described otherwise …. This objective test precludes arguments such as … that an expenditure for entertainment should be characterized as an expenditure for advertising or public relations.

The courts have previously considered boat-related expenses for boats used for clients.  For example, in Catalano v. Commissioner, T.C. Memo. 1998-447, the court noted:

Under an objective test, boats such as petitioner’s are generally considered to be associated with recreation. Petitioner’s own testimony establishes that he used the boats at least in some part for providing entertainment to clients and potential clients. Petitioner has conceded that he invited clients and potential clients aboard his boats, sometimes accompanied by their spouses. On board, although some business discussions may have taken place, petitioner also watched television with his guests and used the stereo. There were three sets of binoculars for his guests’ use, and occasionally petitioner served them food and beverages. Petitioner took his clients or other business contacts for rides on San Francisco Bay. He taught one client, a Mr. Labruzzo, how to operate one of the boats.

The court in Catalano concluded that the boat expenses were non-deductible entertainment expenses.  These cases made it clear that the facts in Duncan are not sufficient to establish that the yacht expenses were anything other than entertainment expenses.  But the law does not stop there.  Since we are considering entertainment expenses more broadly, it’s helpful to continue on.

Pre-TJCA Employer Provided Entertainment

The limitation on entertainment expenses does not apply to some expenses provided by employers to employees.  The regulations specifically address this, explaining that the employer’s deduction for common expenses that could arguably be an entertainment expenses are not limited:

The term “entertainment” does not include activities which, although satisfying personal, living, or family needs of an individual, are clearly not regarded as constituting entertainment, such as (a) supper money provided by an employer to his employee working overtime, (b) a hotel room maintained by an employer for lodging of his employees while in business travel status, or (c) an automobile used in the active conduct of trade or business even though used for routine personal purposes such as commuting to and from work. On the other hand, the providing of a hotel room or an automobile by an employer to his employee who is on vacation would constitute entertainment of the employee.

This provides some certainty to employers that provide these types of business-related “entertainment.”

Pre-TJCA Entertainment Facility Expenses

The limitation on entertainment expenses also does not apply to businesses that operate entertainment facilities.  The limitation on entertainment expenses applied to entertainment as an activity, not as a facility.  The regulations define the term facility as follows:

Any item of personal or real property owned, rented, or used by a taxpayer shall . . . be considered to constitute a facility used in connection with entertainment if it is used during the taxable year for, or in connection with, entertainment. Examples of facilities which might be used for, or in connection with, entertainment include yachts, hunting lodges, fishing camps, swimming pools, tennis courts, bowling alleys, automobiles, airplanes, apartments, hotel suites, and homes in vacation resorts.

The regulations go on to say that expenses incurred at the time of an entertainment activity, even though in connection with the use of facility for entertainment purposes, are not considered to constitute expenditures with respect to a facility used in connection with entertainment.  Examples include the cost for food and beverages, catering, and gasoline and fishing bait consumed on a fishing trip.

Thus, the costs of an entertainment facility are not affected unless the property is used in connection with the taxpayer’s entertainment–not the taxpayer’s client’s entertainment.  The courts had said that any use, no matter how small, for entertainment is fatal to the claimed deduction.

But the IRS has concluded that the costs for an entertainment facility, such as a yacht, are not limited if the entertainment facility is held in a separate entity and is used in a business for third parties (i.e., it is held for rental to third parties, such as a yacht rental business).  See, e.g., TAM-142791-01.

Entertainment Expenses Post-TJCA

The TJCA changed the law to say that no deduction is allowable “[w]ith respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation….”  So where does that leave us?

The Treasury has yet to issue updated regulations.  Thus, the objective standard for identifying entertainment expenses still stands.  The exceptions for employer-provided expenses and entertainment facilities also stand.

Pending the issuance of new regulations, taxpayers can–and no doubt will–structure their affairs to avoid the limitation on entertainment expenses.  Like in the Duncan case, this may include attempts to classify entertainment expenses as advertising expenses.  It may also include tracking expenses closer to distinguish between different subcategories of expenses, such as allowable but limited meals versus entertainment expenses.

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