One of the greatest benefits of being a business owner is that you get to pay for business expenses with pre-tax dollars. Another way to put that is, you get to take expenses you incur and deduct them from your taxable income. If positioned correctly, this can even extend to things like travel, gifts, meals, and pre-2018 entertainment and that’s pretty awesome because it’s going to keep more cash IN YOUR POCKET!
I'm Gabriel Velez, partner at Tehrani & Velez, LLP. We're a Tax and Accounting firm based out of Irvine, California, working primarily with small businesses and real estate investors. Today...in this three part video..I’m going to be talking about some misunderstood and underutilized tax deductions, namely traveling expenses, business gifts, meals, and pre-2018 entertainment.
Ordinary and Necessary
As with any business-related expenses, the expense must meet the “ordinary and necessary” standard to be considered a tax deduction. Furthermore, because of the inherent personal nature of things like travel, gifts, meals, and entertainment ([side bar] people spend money on that stuff even when it’s not for business [side bar]) we have stricter substantiation requirements than other expenses AND, depending on the expense, we can sometimes also face limitations. That being said, those hurdles are well-worth overcoming when you think of the substantial benefits that’ll result on your bottom line.
It’s also worth noting that business-related expenses don’t extend to employees, so if you have employees paying for things for your business out of their pocket, a properly created and implemented employee reimbursement plan is essential for your business and your employees.
Limitations
Due to the inherently personal nature of travel, meals, gifts, and entertainment, limitations are placed on their deductibility. Sometimes these limitations are percentages of the total expense, sometimes they’re dollar amounts, AND sometimes there’s that subjective “Reasonableness” criteria which might limit their deductibility.
Most business meals, on the other hand, are generally only 50% deductible; though there are exceptions where they might be 100% deductible that we’ll discuss in part 3.
Entertainment expenses incurred after 2017 are limited in that they are generally not deductible unless they meet an exception. Prior to that, an entertainment expense would be treated much like meals...50% deductible if ordinary, necessary, and associated with one's trade or business.
One more limitation is that you’re only allowed a deduction of $25 for business gifts given directly or indirectly to each person during a given tax year. And when I talk about business gifts, I’m referring to casual gifts to business associates. This would include things like gift baskets, gift cards, a bottle of wine, etcetera. This doesn’t include donations and contributions to qualified nonprofits and political campaigns, both of which have their own sets of rules.
In practice, the limitations are reported as an adjustment on the tax return. That means when you're doing your accounting you still want the full figures listed on your income statement.
Accountable & Nonaccountable Reimbursement Plans
From time-to-time, there are situations where your employee might pay for expenses related to your business. Common expenses are travel, gas, business meals, and so on. If those expenses are attributable or beneficial to your business you may have a legal obligation to reimburse said employee...plus it’s the right thing to do.
There are two ways to reimburse your employees: number one (1) an accountable plan and two (2) a nonaccountable plan.
An accountable plan is one where your employee turns in periodic expense reports, allowing you to account for the money spent as things like Office Expense, Automobile Fuel, Travel Expense, etc. Because of this accountability, you’re able to exclude the amount paid from your employee’s gross income.
A nonaccountable plan is more of an allowance provided to employees that are earmarked for their business expenses. Because the employer doesn’t have a record of the money that’s actually being spent, reimbursements under a nonaccountable plan are tacked on to the employee gross income.