To entertain or not to entertain…
The Tax Cuts and Jobs Act implemented changes that were enormously beneficial for our clients in 2018. The basic condensing of tax brackets and lowering of just about all tax rates, as well as the vastly improved AMT exemptions, proved to lower the marginal tax rates for a large majority of our client base. The implementation of the Qualified Business Income Deduction also served to lower the amount of taxes paid by many. But before I sing the bill’s praises too loudly, I must mention one change that left many business owners quite unhappy, even the face of significant overall savings…the elimination of tax-deductible entertainment expenses.
This one hurt. Granted, it may be more of an emotional pain than a fiscal one when all is said and done, but it hurt none the less. Previously, 50% of expenses incurred to entertain current and potential clients and referral sources could be deducted if certain requirements were met. Golf outings, baseball games, and night clubs (I always wondered who actually entertained their clients at a night club) could all provide a partial tax deduction if they met the IRS’ “directly related” or “associated” tests. The Tax Cuts and Jobs Act has now removed this deduction and with it, a significant portion of the way many of our clients market themselves and drum up new business. Let’s take a quick look at the new rules as well as what we can take away from them practically moving forward.
As of January 1, 2018, there is no tax deduction for entertainment expenses. Want a technical definition? “Any activity which is of a type generally considered to constitute entertainment, amusement, or recreation…” The regulations also provide an objective test that says if the activity is generally thought of as entertainment…its entertainment. In other words, if it walks/talks/looks like a entertainment, it’s entertainment. There are a few exceptions to this general rule. Most significantly, the rule allowing a deduction for entertainment primarily on behalf of your employees is still intact. These expenses are generally thought of as holiday parties or outings to boost company morale. You can still put on a party for your employees and take a 100% deduction.
The new law also made some changes to expenses for meals. There was thought that the deduction for business meals would also be eliminated. Thankfully, that was not the case and business meals with clients or referral sources are currently still deductible at the 50% rate; no change there. In fact, the IRS has clarified that a deduction is available for a meal that is eaten during an entertainment event as long as there is a separate receipt for that meal. So, if you take a client to a baseball game you can deduct 50% of the cost of those ballpark hotdogs (as long as you get a separate receipt) even though the cost of the tickets is not deductible. To deduct a business meal (at a ballgame or otherwise) either you or an employee must be present. Meals for employees during a work/lunch meeting are still deductible but now at a 50% rate instead of the 100% deduction previously allowed.
So, what’s the take away? Do the new entertainment rules mean you should not take a client out to a Padres game or an afternoon at Torrey Pines. Maybe. But maybe not. Many of our clients generate a good portion of their business through referrals that are based on a personal relationships. If spending an afternoon on the golf course is a great way to build relationships and leads to increased revenue then, yes, you should throw your clubs in the trunk and go hit the course. If it makes good business sense then its worth doing even if you don’t get a tax deduction. After all, you were only getting a 50% deduction for this activity in the first place. In this context I like to remind clients that it’s important not to let the tax tail wag the financial dog. Should the absence of a tax deduction impact the decision? Absolutely, but it’s one factor and should not be the only consideration.