Travel and Entertainment: Top Tax Audit Exposures for Many Small Businesses
While at an industry convention not long ago, at a fancy dinner after a day of golf with other industry professionals, I was asked by one of my good lawn care clients, 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 year’s tax return I replied, “it might be.” With righteous indignation my lawn care client replied “Are You Kidding, this day is absolutely deductible.” Well the answer is he was probably correct but the reasoning was that several tests for deductibility had been passed, rather than it was deductible 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 that the statute of limitations passes thereby avoiding disallowance of those expenses upon audit. Well, as many lawn care professionals have been employing technology in their businesses, the IRS is no different.
In fact, the IRS receives millions of tax returns each year and they just don’t have to resources to go through them all. So they use an automated computer-based scoring system called the Discriminant Inventory Function System (DIF). According to the IRS website, the DIF score rates the potential for change, based on past IRS experience with similar returns, meaning they use their computer system to check for irregularities based on similar returns.
Though the calculation of the actual scoring system is a well-kept secret, the purpose behind 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 is likely that if the deductions you take is outside the norm, you will be audited. This does not mean there will be an audit adjustment, just that you will be audited. How well you keep your records that show you are compliant with the law will determine if there is an adjustment and how much if any.
Understanding Tax Audit Exposures
So what are the rules for deductibility of travel, meals and entertainment? In order 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 the lawn care professional can prove that his attendance primarily benefits or advances the interest of his own employment or business.
Tax Audit Exposures: Travel Expenses
Generally, travel expenses paid or incurred for a spouse or other family member are not 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.
The lawn care professional may generally deduct meals and entertainment expenses incurred for business purposes. However, deductions for meals and entertainment must be reduced by 50%. Specifically, this reduction applies to any expense for food or beverages, and any cost for an entertainment activity. This is the rule that makes meals and entertainment only 50% deductible.
Tax Audit Exposures: Meals and Entertainment
Another rule related to meals and entertainment relates to membership dues to social or country clubs. The lawn care professional must remember that the dues or initiation fees to such clubs are not deductible although amounts expended specifically for business meals and entertainment while at these clubs is deductible subject to the 50% limitation.
For purposes of travel, the lawn care professional can deduct all travel expenses if a trip was entirely business related. If the trip was primarily for business but extended a few days to make a personal side trip you can only deduct the business related travel which includes cost of getting to and from the business location as well as related expense.
Caveat: With a combination business and personal trip (domestic) there is 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, the business purpose should account for more than half the time spent away in order to deduct the travel.
The burden of proof is on you. In order to deduct travel, meals and entertainment without having them disallowed upon audit, you will need to maintain meticulous records. Specifically stated in the regulations, you cannot deduct amounts that you approximate or estimate. You will need to retain source documents such as receipts cancelled checks, credit card statements and other written evidence of such transactions. In addition if the deduction is for a meeting or convention and there is a brochure with a meeting agenda that you can retain that would be helpful in fulfilling your burden of proof.
Tax Audit Exposures: Facing an Audit
In the case of an audit, timely accurate and well organized information is paramount. While not required, it is 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 does not mean that you have to write down each of your expenses each day. If you maintain a log on a weekly basis that accounts for expenses incurred during the week, the log will be considered a timely-kept record. The IRS considers a timely-kept record more valuable than a statement prepared later when you may not remember the details accurately.
Source documents will normally 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 on the receipt as well as the names of those in attendance
- The date and amount of the expense.
If a charge is made for items other than food and beverages, the receipt should show that this is the case.
Tax Audit Exposures: Keep your records!
How long will you need to keep these records? You must keep records as long as they may 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 3 years from the date you file the income tax return on which the deduction is claimed.
While the above may seem overly burdensome, if you don’t follow the guidelines don’t be surprised if you get audited and you are precluded from taking a deduction listed on your tax return and are forced to repay the tax as well as subject to penalties and interest. A good reading of IRS publication 463 should provide the information needed to comply with the tax laws as they apply to the deductibility of travel, meals and entertainment.