GPSOLO April/May 2010
Business or Pleasure? Tax Traps
The lines between business and pleasure expenses and the federal income tax deduction of such expenses are not always clear. This article will explore the federal income tax aspects of the following items:
- client meals and entertainment;
- country club dues;
- wife’s or husband’s expenses when accompanying a spouse to a business meeting or convention;
- mixed business and vacation expenses (e.g., the “working” cruise to Alaska);
- second homes, vacation homes, and rentals; and
- hobby expenses.
Expenses in these areas might not initially seem deductible, but they can become so. In every one of the above scenarios, however, the tax law is complex, and this article will not attempt to define all intricacies of the tax law. Instead, this article aims only to give a general overview for the reader, so that the reader can delve more deeply into the subject if he or she so desires or consult with a tax advisor for a more thorough explanation.
Client Meals and Entertainment
Generally speaking, expenses associated with client entertainment and meals are income tax deductible subject to certain limitations. If the expense is directly related to the act or conduct of your business (such as the practice of law) or the associated entertainment expense is directly associated with the specific trade or business, such business expenses are generally deductible. Client meals and entertainment are subject to the “ordinary and necessary” rule under the Internal Revenue Code. The term “ordinary and necessary” under the Internal Revenue Code means that the expense is reasonable based on the facts and circumstances surrounding the expense. An “ordinary” expense is one that is common, accepted, and customary in the taxpayer’s business environment. A “necessary” expense is one that is appropriate to the taxpayer’s business. A lawyer who takes a client to a fine restaurant for business purposes can deduct the cost of such meal at the fine restaurant. However, the deduction is limited to 50 percent of the total expense. Let’s presume that you take a client to a fine restaurant and spend $250 for the meal including a bottle of wine. The deduction for the $250 expense is limited to $125 for federal income tax purposes.
Meal expenses are not deductible if neither the taxpayer nor the taxpayer’s employee is present at the meal, and a deduction will not be allowed for food and beverages to the extent that such expense is lavish or extravagant as determined by the Internal Revenue Service (IRS) and court cases. The taxpayer needs to keep receipts for these types of expenses to claim the 50 percent deduction. However, if you go to a city and would rather not keep receipts for meals, then a per diem allowance may be used under IRS guidelines. You can find the actual federal per diem meal expense allowance in various CONUS (continental United States) cities at the website www.gsa.gov. It might be to your advantage to use a per diem expense rather than actual meal expenses, especially if you go to a high-cost per diem city and your actual meal expenses are less than the per diem expense allowed by the IRS for that city. Effective October 1, 2009, the per diem for meals in various CONUS cities ranges from $46 to $71. If you are an unincorporated sole proprietor, you are entitled to take per diem deductions for meals but not a per diem allowance for hotels.
What if a client invites you to attend a planning luncheon for committee members of a golf tournament for a charity recognized by the IRS? Let’s say you pick up the $200 tab for everyone’s meal, including your client’s, and the other parties present are prospective clients. What is deductible? In this case, because it can be interpreted as a charitable contribution, the full $200—rather than 50 percent—is deductible under IRS guidelines.
Entertainment generally includes entertaining clients at night clubs, sporting events, theaters, and other similar types of entertainment. Review Section 274 of the Internal Revenue Code for a more thorough overview of regulations regarding these types of expenses.
Country Club Dues
No business tax deduction is permitted for country club dues and assessments. Generally, the above rule extends to business, social, athletic luncheon, and sporting type clubs. However, let’s say that you belong to your local Rotary Club or Lions Club; dues paid to these public service organizations are generally tax deductible if paid for business reasons and the club’s principal purpose is not to conduct entertainment activities or have facilities for members or their guests.
Spouse Attending Convention
Deducting the cost of your spouse’s expenses on your business trip is a delicate proposition under IRS guidelines. You cannot deduct these travel costs unless your spouse is an employee of your business, and even then his or her presence on the trip must serve a bona fide business purpose. Having your spouse perform some incidental business function on the trip isn’t enough to establish the business purpose. Even if your spouse’s travel doesn’t satisfy IRS requirements, you’ll still be able to deduct a substantial portion of the total trip’s cost for you and your spouse. There is no allocation of 50 percent of travel costs to your spouse. You need only allocate to your spouse any additional cost you incur for him or her. The cost for a double room is not that much higher than the cost to obtain a single room; although the additional incremental costs of the double room rather than the single room is not deductible, the initial cost of a single room is still deductible. If you drive or rent a car, the costs will be fully deductible even if your spouse accompanies you. And, of course, you can deduct your own seminar and convention costs so long as such expenses relate to your business or profession.
Although there is no limit on the number of foreign conventions and vacations you can attend and deduct on your income tax return, the rules change if you try to deduct cruise ship expenses. The government has a difficult time understanding how serious conventions are held aboard luxury cruise liners—and will not easily grant a deduction—unless the following conditions, among others, are met: The convention or meeting must be directly related to your trade or business; the cruise ship must be U.S. registered; and all ports of call must be located within the United States or possession countries. Even when the above criteria are met, the maximum deduction is $2,000 per year for each taxpayer, and you must attach two written statements along with the above-referred requirements. The first statement, signed by you, must include information such as how many days were devoted to the scheduled business while on the cruise. The second statement, signed by a representative of the sponsoring organization, must include a schedule of the business activities each day and the number of hours you personally were in attendance. In light of these requirements, I advise my clients to keep a diary of all of their daily activities on the ship.
You can deduct your cruise to Alaska or U.S. possession countries if a number of other criteria are also met. There are important rules that make a cruise deductible, including a certification that the tax law makes the cruise ship a defined alternative to air travel. (The criteria for such certification are beyond the scope of this article; consult your tax advisor for more details.) Once you have this certification, you can deduct the cost of a cruise even though you can take an airplane to get to your destination in one day or less. There are safe harbor rules that can protect your cruise ship deductions for trips outside the United States. However, it is better to cruise domestically for tax deduction purposes.
The law applies special rules for conventions, meetings, and seminars aboard cruise ships. Before you book that cruise, you need to make sure that the tax law sanctions the business-related activity you plan to attend. If you want to take the cruise and you want to attend a convention on the ship, the law gives you two choices: You can use the cruise ship as transportation, or you can use the cruise ship as if it were a hotel where the meeting or convention is located. You also must meet the “ordinary and necessary” requirement previously discussed under IRS rules. You get the best tax breaks when you use the cruise ship to travel to your business meeting. Rules regarding length of stay on the ship are very complex; review the IRS rules for more details of the applicable regulations.
Special rules limit the amount of deductions that may be taken by an individual in connection with the rental of a residence or vacation home that is also used as a taxpayer’s residence. Some deductions that may be claimed without regard to whether or not the home is used for a trade or business or the production of income such as mortgage interest expenses and property taxes are not limited. A vacation home is deemed to have been used by the taxpayer for personal purposes on a particular day if for any part of the day the home is used for personal purposes by the taxpayer’s family, by any individual who uses the home under a reciprocal arrangement, or by any other individual who uses the home unless a fair rental is charged for the home. If a party rents the home at a fair market rental value to any person for use as that person’s principal residence, the use by that person is not considered personal use by the taxpayer.
The term “vacation home” under IRS guidelines means a dwelling unit including a house, apartment, condominium, boat, or other, similar type of property. If the property is rented for fewer than 15 days during the year, no deductions attributable to such rental are allowable, and no rental income is includable in your gross income. If the property is rented for more than 14 days during the year, deductions are available. When the personal usage exceeds the greater of either 14 days or 10 percent of the rental days under IRS rules, expenses attributable to the use of the rental unit are limited in the same manner as prescribed under the hobby loss rules discussed below.
Let’s say you are an avid racehorse enthusiast and want to deduct the costs associated with this hobby. Losses incurred by individuals and other types of entities that are attributable to an activity not engaged in for profit—so-called hobby losses—are generally deductible only to the extent of income produced by the activity. Certain types of expenses, such as taxes, interest, and casualty losses, are deductible whether or not they are incurred in connection with a hobby and even if these expenses are greater than the hobby income. An activity is presumed not to be a hobby if profits result in any three of five consecutive tax years ending with the last tax year in question, unless the IRS proves otherwise. An activity involving the breeding, training, showing, or racing of horses is not considered a hobby if profits result in two out of seven consecutive years. Thus, you can engage in a racehorse business and deduct many of the expenses if such expenses are ordinary and necessary for that particular type of business.
Having worked for the IRS and currently working on cases with IRS revenue and estate tax agents, I have learned that the bottom line is simple: Always be reasonable. Any taxpayer can use the above tax pointers, but keep in mind the “ordinary and necessary” rule under the Internal Revenue Code for all of your tax planning. Be reasonable when taking deductions, do not try to overreach, and always research the tax law thoroughly before taking any action.
Any law changes in effect after January 1, 2010, are not reflected in this article. In preparing and researching for this article, the author reviewed sections of the Internal Revenue Code and the regulations thereto as well as the U.S. Master Tax Guide, 2010 Edition, and other authors’ treatises.
IRS Circular 230 Disclaimer: If the foregoing includes any tax advice, while we maintain our responsibility to you with respect to such advice, it is neither written nor intended to be used, and cannot be used, for the purposes of avoiding federal tax penalties. A formal opinion meeting specific requirements set forth in the new U.S. Treasury guidelines may be required to avoid federal tax penalties.
Dennis J. Jacknewitz practices law in Belleville, Illinois, and formerly worked as an attorney with the Internal Revenue Service; he may be reached at firstname.lastname@example.org. The author acknowledges with gratitude the significant assistance of Wenzel & Associates Ltd., Certified Public Accountants in Belleville in preparing this article.