The IRS has special rules regarding writing off entertainment expenses, and if interpreted the wrong way, small-business owners can find themselves in hot water with the agency.

As we head into the holiday season filled with business events and parties that tend to be full of not only fun festivities, but also marketing and advertising opportunities, it’s important to keep in mind that the IRS is very strict with its tax-write off standards.

Entertainment is an ordinary and necessary business expense. After all, you need to be in touch and ingratiated to your client list in order to ensure a continuing business relationship. It’s also important to network and hobnob with associates in related industries so that they will remember to refer business your way. And so the expense of providing food, drink, music, etc. should be deductible. Right?

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Well, it’s not that straightforward. Having a party for business associates and clients simply to promote goodwill is not a valid deductible expense. And if it’s presented that way in audit it will be disallowed – usually with a snicker from the auditor.

Bear in mind that with any entertainment expense, including parties, there must be a substantial business discussion before, during, or after the event. One exception is if the party is thrown for the benefit of employees and their families only – you know, the proverbial company holiday party. That expense is 100% deductible. If the general public is invited it’s 100% deductible as well. If the party includes friends, the portion allocated to their entertainment is not deductible at all.

A party for business associates and customers must have a business element. There must be a presentation, a reveal, a speech, something that smacks of “substantial business discussion” in order to write it off. And even at that, the other rules for entertainment apply, which means you may only deduct 50% of the expense.

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Well, as indicated above, unless you can allocate a certain portion to the attendance of employees, then that portion is 100% deductible. For example, 50 employees, 50 customers and 50 friends attend your party. The party costs $1,500. You will be allowed to write of $750 - $500 (100% deduction) for employees, $250 (50% deduction) for customers and zero for your buddies.

Documentation is important to ensure that the deduction will fly. Keep a copy of the invitation and make sure the business purpose is indicated. For example, “You are cordially invited to experience the reveal of our new potato peeler. Stay and get drunk with us afterwards.” Then videotape the reveal. Not only is that good for providing proof in the event of audit, but it will likely be a good social media marketing tool.

Also maintain a copy of the guest list. The guest list should be totaled by customers, employees, and friends, if an allocation of the expense is to be used. Make sure that your bookkeeper is aware of the allocation of the expense and books the transactions properly into your accounting software.

Your tax professional should also be apprised of this transaction separately from other entertainment expenses that you incur during the year in order for it to show up properly on the tax return.

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