You take Bill, your best customer, to the local country club and treat him to 18 holes of golf. The golf produces a zero deduction. However, if you take your employees and their spouses and children to the local country club, where they play golf and tennis; swim; and enjoy lunch, dinner, and snacks.
The cost of the country club meals and activity produces a 100 percent tax deduction. (Reg. Section 1.274-2(f)(2)(v))
Deduction for Employee Entertainment
The IRS says that the following types of entertainment qualify for the 100 percent employee entertainment tax deduction:
- Holiday parties, annual picnics, and summer outings
- Maintaining a swimming pool, baseball diamond, bowling alley, or golf course
The IRS makes it clear that the above are examples, and that other types of entertainment also qualify for the 100 percent deduction. The tax code states that “expenses for recreational, social, or similar activities (including
facilities therefor) primarily for the benefit of employees” qualify for the 100 percent deduction. (IRC Sections 274(n)(2) 2018; 274(e)(4) 2018)
Employees on a Powerboat
Here is how the tax court treated a case that’s broader in scope than one involving a holiday party or summer picnic.
During one tax year, American Business Service Corporation (American Business Service Corp. v. Commr., 93 T.C. 449) rented a powerboat 41 times at a cost of $1,000 a day for daylong recreational cruises for its employees and their guests. The company had roughly 100 employees, but the boat would accommodate only about 30 people at a time.
All employees, including owners, managers, and rank-and-file personnel, were eligible to take these cruises, but they had to sign up in advance on a first-come, first-served basis.
The court allowed the full $41,000 deduction for the 41 cruises because the cruises:
- were primarily for the employees,
- did not discriminate in favor of the owners and highly compensated employees,
- were documented as to who cruised and when, and
- passed the “ordinary and necessary” business purpose test.
Who Are These Employees?
In this party section of the tax law, you (as an owner) belong to the “tainted group.”
Technically, the law requires that the entertainment expenses be primarily for the benefit of employees other than a tainted group, which consists of any of the following:
- A highly compensated employee (an employee who is paid more than $130,000 in 2021)
- Anyone (this likely includes you) who owns at least a 10 percent interest in your business, i.e., a “10 percent owner”
- Any member of the family of a 10 percent owner, i.e., brothers and sisters (including half-brothers and half-sisters); spouses; ancestors (parents, grandparents, etc.); and lineal descendants (children, grandchildren, etc., including adoptees)
Remember, as the business owner, you belong to the tainted group. That’s not a big deal. You just need to make sure that partying with the employees is primarily for the benefit of the employees.
“Primary” Means “More Than 50 Percent”
In tax law, the words “primary” and “primarily” mean “more than 50 percent.”8 For employee recreation, that means the untainted group of employees has to have more than 50 percent use of the entertainment facility—or in the case of a party, a majority of the attendees must come from the untainted employee group.
Documentation tip. You can measure “primary” by days of use, time of use, number of employees, or any other reasonable method. Regardless of how you measure use, the key to your deductions is the records that prove the uses.
Easy-to-Meet Business Purpose Requirement
As you may remember, the Tax Cuts and Jobs Act eliminated deductions for business entertainment, but not for entertainment primarily for the benefit of employees. (Reg. Section 1.274-2(f)(2)(v))
You still need to satisfy the overriding standard for business expense deductions, which is the ordinary and necessary business purpose test. (IRC Section 162(a) 2018) Fortunately, this test is easy to pass.
Basically, an ordinary and necessary expense simply means an expense that is “appropriate and helpful” for your business. To meet the test, the expense does not have to happen often or be a recurring expense. (Capital Video Corporation v Commr., 90 AFTR 2d 2002-7429 (CA1) Nov. 27, 2002)
What’s your ordinary and necessary reason for partying with your employees?
Your reason might be as simple as improving employee morale and loyalty to your business. Or you may want to ensure that your business is more fun and has better working conditions than the competition has.
You must document your 100 percent deductible employee entertainment expenses, just as you must document other expenses.
Documentation tip. When recording the expenses for an employee party, outing, or other type of entertainment, be sure to note your business reason for the entertainment.
- If it’s an annual event to improve employee morale and loyalty, write that down.
- If there’s a more specific reason, such as an office party to celebrate a fat new contract, write that down.
The point is, you need a reason, and you need to write it down. This test is easy to meet, but like all deductions, you can’t nail it down without writing it down.
Chart of Accounts
In your chart of accounts, make sure you have a category for the 100 percent deductible employee functions. Without a category, you could mistakenly put the company picnic in the non-restaurant business meals category and lose 50 percent of the deduction when you file your tax return.
“Employee welfare benefits” has a logical ring to it as a chart of accounts category for the 100 percent employee entertainment deductions. It also matches a category in most business tax returns.
In conclusion, make sure you document that your outings primarily benefit the employees and not the tainted group. Also, make sure to put the expenses into a chart of accounts category where you will realize the full 100 percent deduction.