Proving a business connection for meals and entertainment.

• Author: Ellentuck, Albert B.

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 17th edition (March 2016), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).

Entertainment includes any activity generally considered to provide entertainment, amusement, or recreation (Regs. Sec. 1.274-2(b)(l)). Meal and entertainment expenses incurred by a taxpayer to entertain a client, customer, employee, or other business associate are deductible only if the expenses satisfy the following strict requirements imposed by the Code:

* Ordinary and necessary: Meal or entertainment expenses must be ordinary and necessary to be deductible (Sec. 162(a)). An ordinary expense is one that is common and accepted in the taxpayer's business, trade, or profession. A necessary expense is one that is helpful and appropriate, although not necessarily indispensable, for the employer's business, trade, or profession.

* Business connection: There must be a clear connection between the meal or entertainment and a business event (such as a discussion, meeting, transaction, or negotiation). That is, the taxpayer must prove a valid business purpose for the business event that occurs before, during, or after the meal or entertainment activity (Sec. 274(a) and Notice 87-23).

* Lavish or extravagant: The meal or entertainment cost is deductible only to the extent it is not lavish or extravagant under the circumstances. Any portion deemed to be lavish or extravagant is not deductible. The remaining portion is deductible (Sec. 274(k)).

* Substantiation: A deduction is allowed only for meal or entertainment expenses that are properly substantiated (Sec. 274(d)). No substantiation means no deduction.

* Taxpayer's presence: The taxpayer or a representative must be present when the activity involves business meals. Otherwise, the cost of the meal is nondeductible (Sec. 274(k)).

Of these requirements, the business connection requirement imposed under Sec. 274(a) is perhaps the most difficult to meet. This requirement focuses on the reason for which the taxpayer's expense is paid or incurred and requires a business connection between the expense and the taxpayer's trade or business. Meals or entertainment for which the taxpayer fails to show a clear business connection are deemed personal (nondeductible) expenses.

Distinguishing "Directly Related" and "Associated With" Entertainment

Business meals or entertainment activities can occur before, during, or after the related business event (i.e., business meeting, discussion, negotiation, etc.). Thus, these business expenses are deductible if they qualify under either of the following tests:

* "Directly related" entertainment: The business event and the entertainment activity occur simultaneously.

* "Associated-with" entertainment: The entertainment activity precedes or follows the business discussion.

Under the business connection requirement, meal or entertainment expenses are not deductible unless the taxpayer establishes that the item was directly related to the active conduct of the taxpayer's business, or in the case of an item directly preceding or following a substantial and bona fide business discussion, that the item was associated with the active conduct of the taxpayer's business. It is often more difficult to prove a business connection for directly related entertainment than for associated-with entertainment.

Directly Related Entertainment

A meal or entertainment activity that occurs while business is being conducted (i.e., a combined entertainment-business event) must meet the following requirements to be deductible as directly related entertainment (Regs. Sec. 1.274-2(c)(3)):

* Main purpose: The primary purpose of the combined entertainment-business event is the active conduct of the taxpayer's trade or business. It is not necessary that more time be devoted to business than to entertainment to meet this requirement. However, business discussion that is only incidental to the entertainment does not satisfy this requirement.

* Active business: The taxpayer actively engages in a business meeting, discussion, negotiation, or other bona fide business transactions during the entertainment period.

* Profit expectation: The taxpayer had more than a general expectation of getting income or some other specific business benefit from...