S corp. cannot deduct cost of leasing entertainment facility.

In Patrick E. Catalano, TC Memo 1998-447, an S corporation could not deduct any amounts paid to its sole shareholder for the lease of his powerboats used to provide entertainment for his clients. Catalano reported the S corporation's lease payments for the boats as rental income on Schedule E of his individual Federal income tax returns; he also deducted expenses relating to the boats on these Schedules E. (These expenses included depreciation, repairs and maintenance, property taxes, interest, insurance and slip fees.) For 1990, 1991 and 1992, Catalano's corporation deducted 80% of the lease payments on its Federal corporate income tax return under Sec. 274(n).

Facts

Catalano was the sole shareholder of an S corporation. He owned three powerboats, which he leased to his corporation for various periods in accordance with written lease agreements executed by Catalano, as an individual lessor and on behalf of his corporation, as lessee. Catalano invited clients, potential clients and their spouses aboard his boats, mostly on the weekends. While on board, Catalano and his clients (or potential clients) did have business discussions.

The Tax Court held that Catalano's treatment of the lease payments and related expenses on his individual returns was correct; however, it denied a deduction to the S corporation for the lease payments, because these payments were related to the use of an entertainment facility.

Entertainment Facilities

Under Sec. 274(a)(1), no deduction shall be allowed for any item with respect to an activity, or entertainment facility used in connection with such activity, considered to constitute entertainment, amusement or recreation, unless it is established that the item was directly related to (or, in the case of an item directly preceding or following a substantial and bona fide business discussion, that such item was associated with) the conduct of the taxpayer's trade or business. The term "entertainment facility" encompasses any real or personal property owned, rented or used by a taxpayer. This includes boats, automobiles, aircraft and homes in vacation resorts. Any entertainment use of the property, no matter how minimal, will result in the property being characterized as an entertainment facility.

According to Regs. Sec. 1.274-2 (e)(3)(i), nondeductible expenditures for an entertainment facility generally include depreciation and operating costs, such as rent and utility charges, expenses for maintenance, preservation or protection of a facility, salaries and expense for subsistence paid to caretakers or watchmen, and losses realized on the sale or other disposition of a facility. However, there are two sets of exceptions to the general disallowance rule for entertainment expenditures.

First, Kegs. Sec. 1.274-2(f) defines nine specific exceptions to the rule barring deductions for entertainment expenditures, which, if applicable, would include entertainment facilities:

1. Food provided to employees furnished on an employer's business premises.

2. An employer's entertainment expenditures if the employer treats them as compensation and wages subject to withholding.

3. In some cases, reimbursed entertainment expenses.

4. An employer's expenses for recreational, social or similar activities primarily for the benefit of employees.

5. Expenses directly related to business meetings of the taxpayer's employees, stockholders, agents or directors.

6. Expenses related and necessary to attendance at a business meeting or convention of certain exempt organizations.

7. Expenses for goods, services and facilities made available by the taxpayer to the general public.

8. Expenses for goods, services or use of facilities that are sold by the taxpayer to customers for full consideration.

9. Expenses for goods, services and facilities provided to nonemployees as either compensation or a prize.

In Catalano, none of the following exceptions were met; therefore, no deductions were allowed. The disallowance of the entertainment facility expenses was based solely on the statutory prohibition on deducting entertainment facility expenses. Catalano claimed that his boats were essentially second offices where he conducted his business. The court rejected this claim on the grounds that any expenses incurred in conjunction with the use of an asset as an entertainment facility (no matter how minimal the entertainment use) were not deductible if none of the exceptions was met.

Second, Regs. Sec. 1.274-2(e)(3)(iii) provides an exception from the general disallowance rules for "out-of-pocket" expenses incurred at the time of an entertainment activity, even though in connection with the use of a facility for entertainment purposes (such as food and beverages, or expenses for catering, gasoline and fishing bait consumed on a fishing trip).

Entertainment expenditures that are deductible because they meet an above exception still must be deductible as an ordinary and necessary business expense or an expense for the production of income. The term "ordinary" means that the expense must be one that is customary or usual within the experience of a particular business community.

The term "necessary" means that the expenditure must be appropriate and helpful for the development of a taxpayer's business. The expense must be made with the intent of securing a business benefit. A taxpayer would have to demonstrate that a business benefit was intended or resulted from the expenditure. If the taxpayer cannot demonstrate this, the expense is not deductible. Simply put, all expenses that result in only personal use are not deductible. In Catalano, the expenses were not considered ordinary and necessary by the court and, therefore, were not deductible.

Finally, Sec. 274(n) generally provides that any expense for food or beverages, and any item for an activity that is generally considered to constitute entertainment, amusement or recreation, or for a facility used in connection with such activity, shall not exceed 80% of the amount of such expense allowable as a deduction.

Documentation

To substantiate any deductions taken for entertainment facilities, a taxpayer should implement policies and procedures that will ensure proper documentation of the expenses, maintaining the following information to establish that an entertainment activity has been used for the furtherance of the taxpayer's trade or business:

* The date the facility was used.

* Whether the use was business or personal.

* A description of the taxpayer's "business purpose" for providing the entertainment facility, including any business benefit derived or expected and the nature of any business discussion with the person entertained.

* A description of who used the entertainment facility (including the taxpayer) and the person(s)'s business relation to the taxpayer. This may be indicated by reference to name, tide, occupation or other designation sufficient to establish the relationship.

* The business miles or hours flown.

* The amount and description of each expenditure.

* The time and place the entertainment was provided.

* The date and duration of the business discussion(s) that took place.

* The place where the business discussion(s) was/were held.

* The nature of the discussion, its purpose and the benefit derived or expected from the discussion.

In Catalano, the court held that the taxpayer failed the substantiation test. However, even if the taxpayer had provided proper documentation, the expenses would have still been disallowed based on the statutory prohibition on deducting entertainment facility expenses.

A key question is what Catalano could have done differently. The facts indicate that he leased his boats to his corporation and his corporation did make lease payments. While Catalano had to pick up these lease payments as income on his individual tax return, his corporation was disallowed a deduction for these payments. To avoid the nondeductibility of these expenses, Catalano could have used his boats personally to entertain clients. He did not have to lease these boats to his corporation. Under this scenario, he would not have lease income to report on his individual income tax return. His corporation would have remained unaffected, due to the fact that the lease payments were not deductible. A downside to this scenario, however, is that Catalano would incur "out-of-pocket" expenses to entertain his clients, which he would not be able to deduct. This would seem like a more logical choice to creating rental income to offset entertainment facility expenses. It appears that, if the transaction had been better researched and planned, it could have been structured to avoid negative tax consequences.

Conclusion

The Service generally does not allow a taxpayer to deduct any expenditures related to entertainment facilities. However, there are exceptions to this rule. For expenditures for the use of entertainment facilities to be deductible, the expenditures must (1) meet one of nine exceptions, (2) be an ordinary and necessary business expense or an expense for the production of income and (3) be properly and completely documented. With correct tax planning for entertainment facilities, the costs of these facilities can be deducted in some circumstances.

FROM MICHAEL S. SILVIO, CPA, PASADENA, CA