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updated 4/10/2011 3:17:39 AM ET 2011-04-10T07:17:39

Many business owners believe that just because there is a line item on the tax return for meals and entertainment deductions that just about any dinner or theatre ticket or sporting event involving a client or potential client qualifies as a valid deduction. Wrong. It isn't that straightforward or easy.

There are rules. Essentially, the rules say: If you're having way too much fun, it's not a deductible expense. Here's a primer on when entertainment expenses count as business or pleasure.

1. Get down to business. 
First, any entertaining you do must be directly related to the active conduct of your business or associated with a directly related discussion that preceded or followed the meal or entertainment. So if you take me to lunch and we don't discuss tax planning strategies, sales projections or problems with your general ledger, and instead only talk about your 10-year-old's blooming soccer career, then you won't be able to write off the lunch. 

This goes for party throwing, too. No matter if the goal of the soiree is to build goodwill, to deduct the cost of the party, you must conduct business before, during or after the party. That means you need to include a product demonstration, a reveal of a new product or service, a sales pitch or an educational talk related to your product or service. 

the 50% rule

2. Keep your wits about you. 
The environment must be conducive to conducting business. An overly-boozy brunch, for instance, wouldn't qualify. The IRS once rejected a deduction of tickets to a baseball game because the volume levels at a ball park don't allow for a comprehensive business discussion. But if the business discussion had taken place prior to the ball game or shortly afterward, it may have been allowed.

But even then, you have to be careful. Giving a sales pitch at the end of a party where liquor has been served is much like talking politics with sugar-infused 5-year-olds. As a write-off, it's not going to fly.

3. Watch your guest list. 
When it comes to writing off party expenses, the guest list also matters. You may deduct 100% of your cost if the party is either open to the general public or if it's for employees and their spouses. 

By contrast, if the party is for clients, potential clients and independent contractors who work with you, then you may deduct only 50% of the cost. If there is a mix of employees and spouses along with clients and potential clients, you may allocate part of the cost as a 100% write-off and the remainder as a 50% write-off based on the number of guests in each category.

4. Don't go overboard. 
Another Internal Revenue Service rule says entertainment can't be "lavish or extravagant." Although subjective and a gray area that can be argued with an auditor, his manager, all the way up to tax court, why bother? Keep it simple. Make sure the entertainment or meal is aligned to your company's budget. If your bottom line is zero, you likely won't be allowed to write-off first-class accommodations for potential clients in town for your party. 

5. Build up your defenses. 
In case the IRS does come knocking, be prepared to defend the deductions you take. If you're having a party, for instance, make sure the invitation announces a business purpose and take pictures of guests inspecting new products or a video clip. Have attendees sign a guest book or track RSVPs so you can prove an accurate allocation of the expense between employees, independent contractors, clients, and potential clients and family members and friends who aren't at all deductible. 

Then, keep all receipts for all expenses incurred. For expenses that cost less than $75, however, a journal entry in your appointment book with the amount, location and names of those you entertained is sufficient.

Copyright © 2013 Entrepreneur.com, Inc.

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