Those infamous Holiday parties are on the horizon, so we thought we’d share these timely tax tips with you~!
Beware. Tax law requires two categories for your entertainment tax deductions. Does your business chart of accounts contain two different accounts for entertainment? It probably should. The two types of entertainment tax deductions are:
1. 50 percent deductible entertainment; and
2. 100 percent deductible entertainment
If you have staff training in your office and you take the staff to lunch, you have a 50 percent deductible entertainment. The 50 percent category is where your regular entertainment deductions go. The 100 percent tax-deduction category is for entertainment that’s exempt from the 50 percent cut, such as the ever-popular employee Holiday party. In this message, we will explain the following concepts:
1. What it means to qualify an employee party for the 100 percent deduction;
2. What types of employee entertainment qualify for this 100 percent deduction; and
3. How tax law defines entertainment that’s primarily for the benefit of employees
Big Tax Deduction for Employee Entertainment
The IRS says that the following types of entertainment qualify for the 100 percent employee entertainment tax deduction:
1. Holiday parties, annual picnics, and summer outings; and
2. Maintaining a swimming pool, baseball diamond, bowling alley, or golf course.
The IRS uses the term “ordinarily” in describing the 100 percent entertainment above, and that makes it clear that more than the above is possible. Lawmakers stated that “expenses for recreational, social, or similar activities (including facilities therefore) primarily for the benefit of employees” qualify for the 100 percent deduction.
Here is how the full Tax Court treated a case that’s broader in scope than one involving a holiday party or summer picnic. During one year, American Business Service Corporation rented a powerboat 41 times at a cost of $1,000 a day for daylong recreational cruises for its employees and their guests. The company had about 100 employees, but the boat would accommodate only about 30 people at a time.
All employees, including owners, managers, and rank-and-file personnel, were eligible to take these cruises, but they had to sign up in advance on a first-come, first-served basis. The court allowed the full $41,000 deduction for the 41 cruises because the cruises:
- were primarily for the employees,
- did not discriminate in favor of the owners and highly compensated employees,
- were documented as to who cruised and when, and
- passed the “ordinary and necessary” business purpose test.
We recently read about an insurance agent who took his staff to Atlantic City, N.J., for an excursion. Obviously, this is not the traditional holiday party, but it qualifies for the 100 percent deduction. Here are the facts in this case:
The owner of the Agency took his employees on an “incentive trip” to Atlantic City. The “purpose” of the trip was for the employees to “learn, study and discuss future production”. The owner admitted that most the time was spent having a good old time and consisted of a two night stay before returning to the office.
The owner has two choices for claiming a business deduction for these trips:
- He could claim the trip as a business training trip, where you have to prove that the primary purpose of the trip is business; or
- He could claim the trip as a recreational event primarily for the benefit of his employees.
His tax preparer suggested that he go with the recreational event for employees, because:
· The owner admitted that they were not doing much work on this trip, and therefore it probably does not qualify as a business trip;
· The recreational event provides a 100 percent write-off of the meals and beverages, whereas the business meeting only provides 50 percent; and
· They don’t have to even think about work if you make the trip a recreational trip primarily for the benefit of the employees!
To deduct trips of this nature, you need proof that the cost of the trip was primarily for the benefit of:
- Employees other than owners;
- Employees who are officers or shareholders; or
- Highly compensated employees.
Example. You own a business and have seven employees, none of whom earns more than $110,000 a year. The eight of you go to Atlantic City for two days of fun. You pick up the tab for transportation, meals, and lodging—that is, you pay for everything but the gambling. (Those who want to gamble have to fund that experience themselves.) You may deduct as employee recreational expenses the money you spend for transportation, meals, and lodging.
Also, as mentioned above, on this employee excursion, your payments for food and beverages do not suffer the 50 percent cut that applies to business meals. You want to make it clear that this trip is for recreational, social, or similar activities primarily for the benefit of employees.
That’s what produces the 100 percent deduction and removes the need to have business meetings.
Not logical. You have to admit that being able to deduct 100 percent of the meal cost on the excursion when you can deduct only 50 percent for heavy-duty business meetings makes no sense. That’s true—it’s not logical—but that’s the way lawmakers put it together, so apply this rule to your benefit.
“Primary.” The word “primary” in tax law means more than 50 percent. For examples, see Revenue Ruling 63-144, questions and answers 60 through 66. This means that your employee recreation has to benefit the rank-and-file more than it benefits the owner and highly compensated group. In this case, the agent has seven employees plus himself—eight people total on the excursion! The Owner gets one-eighth of the benefit, far less than 50 percent; therefore, the trip with the employees to Atlantic City is of primary benefit to the employees, and that makes it deductible. More on this later…
What About You? What things do you do, or could you do, primarily for the benefit of your employees?
Thus, a cruise in the harbor with your two non-family-member employees is primarily for the benefit of the employees. Let’s say you have a beach home. Suppose that, during the year, your employees use the beach home on more days than you use the beach home. Presto! With an ordinary business-use reason, which we discuss later, you have a beach-home deduction.
Who Are These Employees?
Technically, the law requires that the entertainment expenses be “primarily” for the benefit of employees other than a “tainted group.” The tainted group consists of:
- a highly compensated employee (an employee who is paid more than $110,000 in 2011);
- anyone, including yourself, who owns at least a 10 percent interest in your business (this is called a “10 percent owner”);
- any member of the family of a 10 percent owner, i.e., brothers and sisters (including half brothers and half sisters); spouses; ancestors (parents, grandparents, etc.); and
- lineal descendants (children, grandchildren, etc., including adoptees).
Primary Means More Than 50 Percent
In tax law, the term “primary” or “primarily” means “more than 50 percent.” For employee recreation, that means the non-tainted group of employees has to have more than 50 percent use of the entertainment facility, or in the case of a party, a majority of non-tainted employees must attend.
Documentation Tip. You can measure “primary” by days of use, time of use, number of employees, or any other reasonable method. Regardless of how you measure use, the key to your deductions is the records that prove the uses.
Business Purpose Requirement—Easy to Meet
When you think of business entertainment, you likely think of the terms “directly related” and “associated” entertainment. Smile. Those terms do not apply to employee entertainment!
But you still need to satisfy the overriding standard for business expense deductions, which is the “ordinary and necessary” business purpose test. Fortunately, this test is pretty easy to pass.
Basically, an “ordinary and necessary” expense simply means an expense that is “appropriate and helpful” for your business. To meet the test, the expense does not have to happen often or be a recurring expense.
What’s your “ordinary and necessary” reason for partying with your employees? Your reason might be as simple as improving employee morale and loyalty to your business. Or you might want to ensure that your business might offer more fun and better working conditions than the competition.
Documentation
You must document your 100 percent deductible employee entertainment expenses, just as you must document other entertainment.
Documentation Tip. When recording the expenses for an employee party, outing, or other type of entertainment, be sure to note your business reason for the entertainment.
- If it’s an annual event to improve employee morale and loyalty, write that down.
- If there’s a more specific reason, such as an office party to celebrate a fat new contract, write that down.
The point is, you need a reason and you need to write it down. The test is easy to meet, but like all deductions, you can’t nail it down without writing it down!
Documentation Tip. When we meet to begin the preparation of your returns, make sure to tell us that you have both regular (50 percent) and 100 percent deductible entertainment. Start with two categories for entertainment in your chart of accounts. If you give us your Quicken or QuickBooks files, the two separate accounts stand out. If you complete an organizer that has just one line for entertainment, make a note on the tax organizer you fill out for us at tax time.
