The travel and entertainment category is one of the largest tax audit exposures for many small businesses.
While recently attending a fancy dinner after a day of golf with other pest management professionals (PMPs) during an industry convention, I was asked by a client, “Is the cost of this day tax deductible?”
Having just been through a tax audit for another client, where the IRS auditor disallowed most of his travel-and-entertainment deducted on his prior three years’ tax return, I replied, “It might be.” With righteous indignation, my PMP client replied, “Are you kidding? This day is absolutely deductible.” He was probably correct; but the reasoning behind it is that several tests for deductibility had been passed instead of because he was having a great day on the golf course with his buddies.
Many businesses deduct expenses related to travel, meals and entertainment and hope the statute of limitations passes, thereby avoiding disallowance of those expenses upon audit. Well, just like you’ve been employing technology in your business, the IRS has been, too. The IRS receives millions of tax returns each year, but it doesn’t have the resources to review all of them. Instead, the agency uses an automated, computer-based scoring system: the Discriminant Inventory Function System (DIF). According to IRS.gov, the DIF score rates the potential for change, based on past IRS experience with similar returns, meaning the agency uses its computer system to check for irregularities based on similar returns.
Although the calculation of the scoring system is a well-kept secret, the purpose of the programming is likely an attempt to determine which returns would have the most potential of generating additional revenue for the IRS through audit. Traditionally, travel, meal and entertainment disallowances have been a significant revenue generator for the IRS, and it’s likely that if the deductions you take are outside the norm, you’ll be audited. This doesn’t mean there will be an audit adjustment; it means you’ll be audited. How well you keep your records that show you’re compliant with the law will determine whether there’s an adjustment and how much, if any.
Rules for deductibility
For travel, meals and entertainment to be deductible, the expenses must meet the Business Purpose Requirement. Under this requirement, the expenses of attending a convention or other meeting, including the cost of travel, meals, lodging and incidental expenses, are deductible as a business expense, as long as you can prove your attendance primarily benefits or advances the interest of your own employment or business.
Generally, travel expenses paid or incurred for a spouse or other family members aren’t deductible, unless the family member is a company employee, has a bona fide business purpose for the travel and would otherwise be allowed to deduct the travel expenses if not a family member. In general, you can deduct meals and entertainment expenses incurred for business purposes. However, deductions for meals and entertainment – pertaining to any expense for food or beverages and any cost for an entertainment activity – must be reduced 50 percent. This is the rule that makes meals and entertainment only 50 percent deductible.
Another rule related to meals and entertainment relates to membership dues to social or country clubs. The dues or initiation fees to such clubs aren’t deductible, although amounts expended specifically for business meals and entertainment while at these clubs are deductible (subject to the 50 percent limitation).
For travel purposes, you can deduct all travel expenses if a trip was entirely business related. If the trip was primarily for business, but you extended it a few days to make a personal side trip, you can only deduct the business-related travel, which includes the cost of getting to and from the business location, as well as related expenses.
There is a caveat, however: With a combination business and personal trip (domestic), there’s the 51/49 percent rule that precludes a travel deduction to and from the business destination if the trip is more than half personal. Therefore, to deduct the travel, the business purpose should account for more than half the time spent away.
The burden of proof is on you. To deduct travel, meals and entertainment without having them disallowed when audited, you’ll need to maintain meticulous records. Specifically stated in the regulations, you can’t deduct amounts you approximate or estimate. You’ll need to retain source documents such as receipts, canceled checks, credit card statements and other written evidence of such transactions. Additionally, if the deduction is for a meeting or convention, and there’s a brochure with a meeting agenda you can retain, that would be helpful to fulfill your burden of proof.
You must keep records as long as they might be needed for the administration of any provision of the Internal Revenue Code. Generally, this means you must keep records that support your deduction for three years from the date you file the income tax return on which the deduction is claimed.
All this might seem burdensome, but if you don’t follow the guidelines, don’t be surprised if you get audited, you’re precluded from taking a deduction listed on your tax return, are forced to repay the tax, and are subject to penalties and interest. A thorough reading of IRS Publication 463 should provide the information needed to comply with the tax laws applicable to the deductibility of travel, meals and entertainment.
In the case of an audit, timely, accurate and well-organized information is paramount. While not required, it’s a good idea to keep a record book or log of your travel, meals and entertainment expenses backed up by receipts and other documentation.
For your records to be considered timely kept, you should record the expense and supporting information at or near the time of the expense. However, that doesn’t mean that you have to write down all your expenses each day. If you maintain a weekly log that accounts for expenses incurred during the week, the log will be considered a timely kept record. The IRS considers a timely kept record to be more valuable than a statement prepared later, when you might not remember the details as accurately.
Source documents normally will be considered adequate if they show the amount, date, place and essential character of the expense. For example, a hotel receipt is enough to support expenses for business travel if it has all of the following information:
■ The name and location of the hotel.
■ The dates you stayed there.
■ Separate amounts for charges such as lodging, meals and telephone calls.
A restaurant receipt is enough to prove an expense for a business meal if it has all of the following information:
■ The name and location of the restaurant.
■ The number of people served (if not, you should notate this,
as well as the names of those in attendance, on the receipt).
■ The date and amount of the expense.
If a charge is made for items other than food and beverages,
the receipt should show this is the case.
Daniel S. Gordon is a CPA in New Jersey and owns an accounting firm that specializes in helping pest professionals throughout the United States. Visit www.pcobookkeepers.com for information about his firm, PCO Bookkeepers. He can be reached at email@example.com.