If you’re going to throw an employee party, know that you are entitled to a tax deduction for this business expense. However, be careful in how you go about it. It turns out that there are two different kinds of deductions for business-related entertainment expenses—50 percent deductible or 100 percent deductible.
When tracking entertainment deductions, it’s best to keep these two types separate from the beginning. That means keeping two separate accounts for them. So, what is the difference?
50 Percent Deductible Entertainment
Most expenses for entertaining employees or other business contacts will fall into the 50 percent deductible category. You can consider this your usual account for these types of expenses. Here’s an example. Let’s say you take a team out to lunch following a training session. The lunch tab falls into the 50 percent deductible classification.
The Employee Party and 100 Percent Deductible Entertainment
Unlike business lunches, other expenses are exempt from that 50 percent cut, meaning they are 100 percent deductible. The primary example of this is the employee party. When an entertainment expense is chiefly for the benefit of your employees, it may qualify as 100 percent deductible entertainment. Read on to determine whether your party qualifies:
- Which Activities Qualify—According to the IRS, qualifying activities include holiday parties, annual picnics, and summer group outings. You can also deduct the cost of maintenance for employee benefit, such as keeping up a golf course, swimming pool, bowling alley, or baseball diamond. The important thing to remember about this is that in order to qualify, the IRS must deem that these expenses are primarily for the benefit of your employees.
- What the Law States about Benefit—How do you know if your use of time or facilities meets the definition of employee benefit? A sample case may make the term clearer. During one year, American Business Service Corporation rented a powerboat at a rate of $1,000 per day on forty-one separate days. The boat was used for single-day recreational cruises both for employees and their guests. Any employee was eligible to sign up in advance, and the choices were made on a first-come, first-served basis. The court’s decision indicated that the full $41,000 was deductible. Here’s why:
- The cruises were primarily for employees.
- The decision on who participated did not favor owners or other highly-compensated employees over other employees.
- Documentation was kept that recorded who participated and when.
- And, the activities sufficed for the “ordinary and necessary” business purpose test.
How Does This Fit into Your Business?
For tax law purposes, the term “primarily” means greater than 50 percent. So, if you take two employees (who are not your family members) on a recreational cruise, then that activity is more than 50 percent for the benefit of employees because employees make up two-thirds of the group.
This definition does not only apply to numbers of people participating. For instance, if you own a vacation home, and you allow your employees to use it more days out of the year than you do, your vacation home now qualifies for an entertainment deduction! You simply make clear that the home was used for an ordinary business-use reason.
Normally, recreational expenses are not something we think of in terms of business expenditures. Unlike, for instance, traveling for a conference, your employee entertainment does not need to fit any definitions for being directly related to business. The terms for employee entertainment are a bit looser. You simply need to pass the “ordinary and necessary” business purpose test. All this means is the expense should be appropriate to and helpful for your business. Keeping your employees motivated and making your business a competitive employer are perfectly sound reasons for providing employee entertainment.
Exceptions to Watch Out For
You must keep in mind that these activities and facilities must primarily benefit employees. Given this stipulation, you need to understand that certain individuals are considered a part of “tainted groups”. Tainted groups include highly compensated employees (those who earned more than $115,000 in 2014), any person who owns 10 percent interest or more in your business (called a 10 percent owner), or any family member of a 10 percent owner. This includes siblings (full and half), ancestors, spouses, and descendants (biological and adopted).
Obviously, you as the business owner are a member of the tainted group. This does not mean you can’t party with the employees; it just means you have to make sure the partying is mostly for the employees, and watch out for the greater than 50 percent rule. Participants should be more than 50 percent from outside the tainted group for your activity or facilities use to qualify.
Important: Make sure you document the facility usage or activity attendance. You can use any reasonable measurement, such as the number of days of use, the number of times used, or the number of employees participating. The most important aspect of these measurements is that your records prove the uses.
Here are a couple of tips for making sure your documentation meets IRS standards:
- Always note the business reason for any entertainment expenditures, whether it’s an annual morale-booster or a celebration for a newly acquired contract. Write this down and keep it with your other account documentation.
- Let the person who prepares your taxes know that you have two separate categories of entertainment expenses, 50 percent deductible and 100 percent deductible. You can make the whole process easier by keeping separate accountings of each from the outset.
With this advice, you’ll keep your employees pleased and your accounts squared away without much difficulty. Don’t be afraid to join in the fun yourself! Tax-deductible employee entertainment is fairly simple to keep straight as a business expense when you understand what qualifies as 100 percent deductible.
- Reg. Section 1.274-2(f)(2)(v). ↑
- IRC Sections 274(n)(2); 274(e)(4). ↑
- American Business Service Corp. v. Commr., 93 TC 449. ↑
- For example, see Rev. Rul. 63-144, Questions and Answers 60 through 66. ↑
- Reg. Section 1.274-2(f)(2)(v). ↑
- IRC Section 162(a). ↑
- E.g., Capital Video Corporation v Commr., 90 AFTR 2d 2002-7429 (CA1) November 27, 2002. ↑
- IRC Section 274(e). ↑
- http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Definitions ↑
- IRC Sections 274(e)(4); 267(c)(4). ↑
- Reg. Section 1.274-5T(a)(2), referring to items in IRC Section 274(e), which includes employee entertainment expenses. ↑