Giving gifts to your loyal customers can be a smart move for a lot of reasons: It helps you to build a strong customer relationship, it can be a clever marketing tool, and it can get you a tax deduction. However, you can't just deduct the cost of the gift and be done with it; the IRS has some rather tricky limitations on how this particular deduction works.

Defining business gifts

According to the IRS, a business gift is a gift given "in the course of your trade or business." Some gifts could be classified as "entertainment," rather than a gift, for tax purposes -- like when you take a client to a baseball game. However, if you buy a client tickets to an event but don't go yourself, you can treat it either as a gift or as entertainment; it's your choice.

Person holding wrapped gifts

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Business gift deduction limits

When deducting business gifts, you're limited to $25 per person per year. If you give a gift to a member of a customer's family, that counts as a gift to that customer. The exception to this rule (because there's an exception to every tax rule) is when you have an independent business connection to the family member. For example, if Mr. Smith and Mr. Smith's son have both bought things from your company, and you give each of them a gift, you would count them as two separate recipients and could use a different $25 limit for each gift.

Incidental costs, such as packing, shipping, and gift wrapping, don't count toward this limit. Note that in order to qualify as an incidental cost, the expense can't add significantly to the value of the gift. For example, having a gift gold-plated would add quite a lot to its value, so this expense would definitely count toward the $25 maximum.

And speaking of incidental costs, gifts that cost $4 or less don't count toward the $25 limit if they meet both the following requirements: The gift has your company name permanently imprinted on it in some way, and you're distributing a large number of identical items. Calendars, coffee mugs, and T-shirts are examples of gifts that could qualify under these requirements.

How to claim your business gift deduction

Business income tax forms don't include a place specifically for business gift expenses. If you're a sole proprietor and report your business expenses on Schedule C, you'll include your business gift deduction on line 27a -- "other expenses." In Part V of this form, you'll then write "business gifts" on the appropriate dotted line and list the amount you're deducting for all your business gifts (but remember, you can only claim $25 per recipient). Corporations and partnerships similarly include business gift expenses in the "other deductions" section of their tax return forms.

The IRS hasn't raised the $25 limit on business gifts in decades and isn't likely to lift it in the near future, so however unrealistic it may be as a maximum gift deduction, you're stuck with it. If you choose to give gifts that cost more than $25 per person, you'll just have to take the remaining cost of the gift as a loss. Hopefully, the goodwill you get back in response to your gifts may help make up for the pain of being unable to deduct the entire expense.