Client can deduct incentive cruise if not lavish or extravagant

Q: I have been trying to sell my corporate client on the idea of offering a free cruise to its most valuable salespeople. However, the corporation’s in-house travel manager has repeatedly shot down the idea, saying that the trips would not be a tax-deductible business expense if they are on a foreign-flagged cruise ship. I have read that when it comes to corporate incentives, it doesn’t matter which ship, cruise or destinations are involved — they are all tax-deductible. Who is right?

You are. Although there are many tax laws and regulations that strictly limit or outlaw deductions of cruise expenses by passengers, those laws do not apply to pure incentive travel. The corporation can pay for any cruise anywhere on any ship, and deduct it all, if the trip is a reward for performance.

The same rule applies to cruises for customers or independent contractors of corporations. The corporation may reward them with a cruise and deduct the entire cost.

Of course, like all tax laws, there are complications. In order to be deductible to the corporation, the gift must not be “lavish or extravagant.” Amusingly, the IRS defines the term by stating what it is not:

“An expense is not considered lavish or extravagant if it is reasonable considering the facts and circumstances. Expenses will not be disallowed just because they are more than a fixed dollar amount or take place at deluxe restaurants, hotels, nightclubs or resorts.”

Therefore, since the IRS has said that expenses for “deluxe resorts” are not lavish or extravagant, and since cruises compete with resorts for incentive clients, it seems to follow that deluxe cruises are not in that category, either.

The flipside of tax deductibility is that part if not all of the fair market value of the cruise is generally considered income to the recipient, which means that he or she must pay income tax on at least part of that fair market value. To avoid a major tax burden, the corporation can include a cash allowance approximately equal to the taxes that would be owed in an average tax bracket, although that allowance itself would be taxable income.

What probably confused the corporate travel manager was another set of tax rules: When passengers try to deduct their own cruise expenses as business expenses, the IRS imposes drastic and unfair limitations.

You cannot deduct the costs of your own cruise on a foreign-flagged cruise ship. It does not matter whether you are cruising for the purpose of attending business seminars, meetings or conventions on the ship.

There is an exception for what the IRS calls “luxury water travel” for a business purpose, which means travel by ship (instead of an airplane) to a destination for a business purpose. So if a travel agent sails from New York to Bermuda in order to take a Bermuda familiarization trip, the ocean voyage is tax-deductible even on a foreign-flagged ship.

However, there are limits to the deduction: The most you can deduct is twice the highest federal per diem for domestic cities; as of September 2014, that per diem is $374, so the most you can deduct is $748 per day.

Even here, there are exceptions to the exceptions, so consult a knowledgeable CPA or tax lawyer if you have further questions.

Mark Pestronk is a Washington-based lawyer specializing in travel law. To submit a question for Legal Briefs, email him at mark@pestronk.com.