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The key to maximizing your tax savings is knowing the best ways to deduct business operating expenses to produce the very lowest taxable income.
First, you’ll need to learn about deductible business expenses to understand how your business income is taxed.
We’ve written about —and provided examples of— a handful of expense types, including the costs of going into business, and now entertainment, meals, gifts, and travel.
Deductible business entertainment can be any activity for amusement or recreation, as long as it’s for your business’s current or prospective customers, clients, or employees. This includes wining and dining, going out to a nightclub, attending a ball game or the theater, or taking a fishing trip. That’s the good news. The bad news is that there are some major drawbacks and limitations to its use. The rules are described below.
Only 50% of the expense is deductible (with a few exceptions noted below).
Appropriate and accepted. The entertainment must be both:
An entertainment expense does not have to be indispensable for your business to be deductible. Nor do you have to show that you received any business income from the entertainment.
EXAMPLE: Barney’s Building Supplies throws an annual golf tournament for local building contractors. Providing this type of outing—golf, baseball games, and the like—is fairly common in the industry. Barney shouldn’t have a problem deducting 50% of the expense as an entertainment expense.
Related to business. The entertainment also must be for the purpose of bringing in revenue. The entertainment must be either directly related to or associated with your business. Directly related to your operation means that there must be a substantial business discussion during the entertainment. It must occur in a clear business setting, and there must be more than a general expectation of business.
EXAMPLE: Ginny, a housewares wholesaler, hosts a group dinner for her distributors at Glutton’s restaurant. She demonstrates a new electronic toothpick to potential customers while they dine. This should meet the directly related rule.
‘Associated with your business’ means that there must be a substantial business discussion either prior to or immediately after the entertainment.
EXAMPLE: Edmund, a financial adviser, holds a tax- planning seminar for a group of clients followed by an evening at the symphony that he pays for. The symphony trip satisfies the associated-with rule.
Extravagant entertainment. An IRS auditor can reject entertainment deductions that are lavish and extravagant for the business. Use your common sense and don’t be excessive.
Home entertaining. You can deduct only 50% of your costs for wining and dining existing or potential customers or clients in your home.
EXAMPLE: Denise holds a dinner party to show and sell MegaVega Vitamins, a multilevel marketing scheme she got suckered into by her brother-in- law. Denise spent $100 on food and drinks and can deduct $50 under the 50% rule.
Entertaining spouses. You can deduct the costs for spouses of customers or clients included in the entertainment as long as the occasion otherwise qualifies as deductible entertainment. And if other spouses are attending a social event, you can bring yours, too (and deduct the cost).
The following expenses are 100% deductible:
The IRS look closely at business entertainment deductions. Auditors are suspicious of fun- and-games deductions. Keep a guest list of people you entertain, and note the business connection and nature of business discussed. At the same time, I’ve never seen the IRS contact a guest to see whether or not business was really discussed.
C corporation entertainment. Small business C corporation shareholders or employees working in the business have two ways to claim entertainment expense deductions. They may either pay the entertainment expenses and get reimbursed or have the corporation pay the expenses directly. If they pay and are not reimbursed, the shareholder/employees can claim the entertainment costs as “unreimbursed employee expenses.” This is an itemized expense they must claim on Schedule A of their individual income tax returns. This is the least desirable way to claim the expenses because it’s less advantageous taxwise, and it also increases the chances of being audited.
See “Travel,” below, for more on meal expenses while traveling.
Gifts to clients and customers are deductible up to a very stingy limit of $25 per recipient, per year.
You can get around the limit, a little, by adding on the cost of engraving, wrapping, and mailing. Also, if the gift costs less than $4 and your business name is imprinted on it (like a calendar or pen) it doesn’t count against the $25 limit and is fully deductible.
Business travel expenses are deductible as long as they are “ordinary and necessary.” The IRS defines travel as a trip away from your place of business.
There are special rules for business travel expense deductions.
Transportation. Whether plane, train, or automobile, public or private, transportation related to business travel is 100% deductible—except for commuting from home to work. This includes taxis, buses, limos, cash tips, rental cars, tolls, and parking. See “Vehicle Expenses,” below, for special rules that apply to deducting vehicle costs if you use your personal vehicle for business travel.
Baggage and shipping. You can deduct 100% of the cost of transporting items, like sample or display material and personal luggage, as long as it is all needed for your business travel.
Lodging. When a trip takes you away from home overnight, or if you need to rest to perform your job, you can deduct 100% of the costs of overnight lodging.
Meals. You can deduct only 50% of the costs of food, beverages, and tips when you’re on the road.
Lawmakers reason that you would still have to eat if you were at home and home-cooked dinners aren’t deductible.
Tips. Gratuities for services like cab drivers, messengers, and porters are fully deductible for business—with one exception. Only 50% of a tip to a food server can be deducted along with the meal costs, as mentioned above.
Laundry. You can deduct 100% of your costs for cleaning your clothes while you are traveling away overnight on business. You don’t get any deduction for the costs of keeping your businesswear clean while you are at home.
Incidentals. Charges for telephone, Internet access fees, and anything else directly related to your business travel are 100% deductible.
Catching a play while you’re out of town comes out of your pocket, though, unless you are entertaining a client or customer.
You have a choice of how to deduct expenses while traveling away from home on business. Travel costs (other than transportation to your destination, which is deducted separately) are termed “lodging, meals, and incidental expenses” by the IRS.
You can choose either the actual expense or the per diem expense method to deduct meals and incidentals. You will want to figure it both ways and use the one that gives you the bigger tax break.
Actual expense method. With this method, you must keep track of every cent you spend for travel, including food and lodging on the road.
Keep good records, by hand or electronically, and don’t throw away your receipts and credit card statements.
Per diem method. The per diem (per day) expense method is simpler—just take an IRS- approved specific dollar deduction for each day you are on the road. How much you can take depends on where you are traveling.
To find the current per diem rate for where you are going, check the U.S. General Services Administration (GSA) website at www.gsa.gov perdiem. Currently, the standard rate for places not listed in the tables is $142, and listed rates range up to $250 per day for lodging, depending on the location. Meal and incidental expense rates range from approximately $52 to $77 per day.
The per diem method relieves you of keeping close track and records of these expenses, although you still must be able to document the trip and the business nature of the travel. Keep your calendar, day-timer, or appointment book showing the business purposes.
Travel per diem expense deductions for lodging can be used by employees only—not small business owners. However, solos may use the IRS per diem meal rates (rates vary depending on the locale) and then claim the actual expense for their Holiday Inn stay. Check the U.S. General Services Administration (GSA) website for current rates.
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