Business Deductions Are Critical for Tax Savings
Ordinary and necessary costs you incur in running your business can be deducted from your income, which reduces the amount of tax that you will owe.
Every business owner knows: "You have to spend money to make money." What you might not realize is that spending that money can bring you a double benefit. Not only does it help you grow your business, but often the money you spend can be deducted from your business income in determining your taxable income.
Business expenses generally deductible provided these two conditions are met:
- The expenses were "ordinary and necessary
- You kept the records that the IRS requires to support your claims
Spending the time and energy to unearth every legitimate deduction that you can claim is usually your best bet for reducing your taxable income (and therefore your tax bill) as much as possible in the short run.
In the long run, there may be other ways to save even more tax dollars - such as by shifting income to other tax years and by taking advantage of tax credits - that can take a certain amount of advance planning.
For nearly every small businesses, the quest for tax savings should start with maximizing your deductions.
Getting a tax deduction may be nice, but make sure that the deductible expense is justified from a business operations perspective. Particularly if you are in the startup phase of your business, the money you have to spend is limited. You don't want to fall into the trap of justifying the purchase of a gold-plated white elephant by saying: "So what if I really don't need it, it's deductible!"
There are certain threshold issues that apply to all business deductions.
- Business expense versus capital asset. A business expense refers to the amounts paid for an item that is not expected to last more than one year. For example, purchasing copy paper is a business expense; but, purchasing a photocopying machine is not a business expense.
- Appropriateness of the expense. Was the expenditure ordinary and necessary for your business?
- Relation to a business activity. The IRS is keenly aware that taxpayers may be tempted to write off things as business expenses that are really nondeductible personal expenses. If the expense was only partly for business, you'll need to allocate it between the business and personal portion.
- Adequate records to substantiate the deduction. In a tax audit, the IRS agent will ask you to show that the expense was in fact paid. This is where your recordkeeping routines come into play. If you have kept good records, proving your deductions won't be a problem. Remember, on most tax matters, the IRS can require you to prove that your deduction (or other item on your personal or business return) is correct. If you can't do this, the IRS will compute your tax liability based on its view of the question under dispute.
There are a few types of expenses that might be seen as promoting the business, but are specifically made nondeductible by the tax laws.
These include items such as lobbying expenses and political contributions, fines and penalties such as parking tickets, and illegal payments such as kick backs.
For instance, a traveling salesman who receives a speeding ticket must pay it, or risk losing his driver's license and his ability to earn a living. It's arguable that the cost of the ticket is an ordinary and necessary business expense. Nevertheless, the law states that legal fines and penalties are never deductible, so the ticket must be paid out of the salesman's own pocket.
This article focuses on the general rules that apply to all business deductions. Consult our other articles for details of the special rules that apply to some commonly encountered business deductions:
What Tests Must Expenses Meet?
Only expenses that are related to carrying on a trade or business are deductible: Personal expenses are not deductible. In addition, these expenses must be ordinary and necessary for your type of business. Finally, the amount paid must be reasonable under the circumstances.
Business Expenses Must Relate to Your Business
In order to claim a business expense, the expense must relate to your business, not your personal life. That's an easy principle to state, but in real life, the distinction between business and personal can be blurry, especially if yours is a family business or you work out of your home. However, the IRS has come down hard on those who don't keep their personal and business expenses separate, and who attempt to deduct personal living expenses against business income.
A builder was not allowed a business deduction for expenses incurred as a result of his polo playing because he could not show a relationship between those expenses and a true business purpose.
Special rules apply to "high-abuse" items. The tax laws contain many very specific rules regulating areas where business expenses can be most difficult to disentangle from personal expenses.
As a rough rule of thumb, if you're in doubt about whether a particular expense qualifies as a business expense rather than a personal one, ask yourself whether you would still have to pay the expense if you had the same income level but didn't work. If you would still have to pay the expense, there's a good chance that what you have is a personal expense, not a business expense.
There are some personal expenses that can be deducted without regard to whether you are operating a trade or business. Many of these are relevant to those who work out of their homes.
For example, if you itemize, you can deduct your mortgage interest and real estate taxes. Other expenses might be deductible even if they are personal expenses, but the amount of the deduction will be far more limited. Non-business casualty losses are deductible, but not to the extent business casualty losses are deductible.
Allocation Required Between Business and Personal Use
If an expense was incurred partly for business and partly for personal purposes, you need to allocate the expense and deduct only the portion that pertains to business usage. The method of allocation depends on the nature of the expense. It can be done on the basis of time, space, usage, or any other reasonable method.
Vincent hires a maid who cleans both his office and his home. He can deduct that portion of wages and payroll taxes that compensate the employee for the time spent cleaning his office, but not his home.
In addition, he drives his car for both business and personal purposes. He must allocate his car expenses on the basis of the mileage driven for business purposes, as opposed to that for personal or commuting purposes.
Only Ordinary and Necessary Business Expenses Are Deductible
Assuming that you have incurred an expense in connection with your business, you still must establish that the expense was "ordinary" and "necessary" to be justified in claiming a deduction. But, what does "ordinary" mean? And, does "necessary" mean "I'd go out of business if I didn't pay the expense?
The IRS is has adopted flexible definitions for these terms.
Ordinary means an expense is common and accepted in a field of business. Ordinary usually refers to expenses that are frequent and ongoing, such as amounts spend on gasoline or business meals, but can also apply to something that you pay only once, such as an installation fee for a business telephone line.
Necessary is defined as helpful and appropriate to your business. An expense does not have to be indispensable to be necessary.
The cost of a gun purchased for personal protection by an insurance agent, who is sometimes required to make business calls to private homes late in the evening, would not be deductible.
Although the gun might provide great piece of mind, carrying a weapon is not "common and accepted" for an insurance agent. Nor, is it "necessary" because it is not helpful or appropriate to the business of an insurance agent. It would be considered a nondeductible personal expense. A different result might occur if your business was repossessing automobiles.
Business Expenses Must Be Reasonable
In addition to being "ordinary and necessary," a business expense must also be "reasonable." Whether an expense is reasonable depends upon the facts and circumstances in the particular situation.
For example, one case held that providing a chauffeured luxury car to an employee was not unreasonable given the nature of the employment and the congested area in which the car was driven.
Similarly, although entertainment and meal expenses are not deductible to the extent that they are lavish or extravagant, an expensive dinner at an exclusive restaurant might be acceptable under certain circumstances.
Review Your Expenses to Make Sure They Pass IRS Muster
In applying the "ordinary and necessary" deduction test, the IRS isn't looking to second-guess your business decisions. You can expect that almost any expense that's fairly common for your type of business will pass muster without serious question. IRS agents use this test to make sure that:
- the money was actually spent, and
- the expense
- pertains to the business (instead of personal or family needs);
- is not also being deducted elsewhere on the return (such as in the cost of goods sold computation), and
- is a current, rather than capital, expense.
Adequate Records Are Essential
If you claim business expense deductions, you will need to have the books and records to substantiate those expenses. The nature of the documentation depends upon the type of expenses, but you need to be able to prove the amount and purpose of each expense.
All taxpayers are required to keep accurate, permanent books and records so as to be able to determine the various types of income, gains, losses, costs, expenses, and other amounts that affect their income tax liability. These records must be retained for as long as they may be relevant for any tax purpose. This applies to business expenses, as well as all other deductions and income items.
You will need to keep all records that support items on your tax return for at least four years after you file your tax return because the IRS may challenge your return for up to three years after its due date.
For some transactions, such as the purchase of property or equipment for your business, you will need to hold onto the records for at least as long as you hold on to the asset, plus four years.
You Must Be Able to Prove the Expense
In order to claim any deduction, a business owner must be able to substantiate the expense. That is, you must be able to prove two facts:
- the purpose of the expense, and
- that the expense was, in fact, paid or incurred.
A receipt or invoice showing the description and cost of the item, plus a canceled check or credit card charge slip, are two types of documents that prove the amount and purpose of an expense.
In some cases, if you don't have records of a particular business expense, but it's obvious that you must have incurred it, the IRS will estimate the amount of your expenses and allow you to deduct only that amount when your return it audited. An example would be a retailer who has incomplete records of inventory purchases: The IRS will come up with a reasonable estimate of what the purchases should have been.
However, there are some expenses that must be supported by hard evidence to be allowed as deductions. Expenses that are particularly susceptible to cheating are subject to special documentation rules and must be proven by adequate records or other evidence.
If you have no records, the deduction will be completely disallowed—the IRS and the courts will not estimate an allowable amount.
The following are expenses that require careful documentation:
The recordkeeping (substantiation) rules for these expenses are discussed in the articles related to the particular expense.
There is no requirement that you keep a contemporaneous log or journal of your deductible expenditures. However, when you make a purchase or incur an expense, the sooner that you record the expense (and provide necessary documentary evidence), the more accurate your records are assumed to be by the IRS and the more valuable the records will be to prove the deduction.
What's more, if you get into the habit of systematically recording your expenses and all the necessary supporting facts and records, you may discover that you have many more perfectly legitimate deductions than you thought!
How to Claim Business Expense Deductions
How you have organized your business (e.g., as a sole proprietorship, S corporation or regular corporation) determines the IRS form you'll use to claim your business deductions.
- If you operate your business as a sole proprietorship, you will report business deductions on Schedule C of Form 1040. (You can use the simpler Schedule C-EZ if your business expenses are under $5,000, you do not have inventory or employees, you use the cash method of accounting, and certain other requirements are met.)
- If you do business as a partnership, you'll file Form 1065 that will report the expenses for the partnership. Certain expenses will be passed through to you on a Schedule K-1.
- A single-member LLC is treated like a sole proprietorship, unless you have made an election to have the LLC taxed as a corporation. A multi-member LLC typically is treated like a partnership, unless you have made an election to have the LLC taxed as a corporation.
- If you operate as a corporation, you'll file Form 1120 or Form 1120-S for S corporations. If you file Form 1120-S, some expenses will flow-through to you and be reported to you on a Schedule K-1
Checklist: Deductible Business Expenses
To help you decide whether a particular expense is likely to be deductible, we've provided a list of the most common business deductions.
- bad debts from sales or services (for those using accrual accounting)
- bank fees on business accounts
- car and truck expenses
- commissions and fees
- cost of goods sold
- dues for trade associations and other not-for-profit, business-related organizations
- employee benefits
- gifts to customers, suppliers, etc.
- insurance (casualty and liability)
- legal and professional services
- meals and entertainment
- office expenses
- pension and profit-sharing plans
- rent or lease expense
- repairs and maintenance (but new--and very complicated--rules apply beginning in 2014, so work with your accountant to avoid unpleasant surprises!)
- services performed by independent contractors
- supplies and materials (not included in cost of goods sold)
- travel expenses
- wages of employees
If you don't see an item you're interested in on this list, check our list of common nondeductible expenses, below.
Checklist: Nondeductible Business Expenses
Listed below are some commonly encountered items that usually won't be allowed as a business expense deduction. In most cases, a deduction is denied for these items either because they are nondeductible personal expenditures, or because Congress specifically made them nondeductible.
The costs that you occur for "capital assets," are not treated as business expenses. However, some, or even all, of the cost might be able to be subtracted from your gross income in the year of the purchase. See the article on capital expenses for more information.
The fact that a particular item is not included on this list does not guarantee that the expense will be deductible. Any expense will be nondeductible if it does not meet the general business expense deduction rules.
Whether a particular expense meets the deductibility requirements will depend on the facts and circumstances of your business.
Nondeductible expenses include:
- bar or professional examination fees
- clothing, unless it's protective equipment, or a uniform that would not be worn during non-working hours
- country club, social club, or athletic club dues
- commuting expenses
- estate or inheritance tax (even if largely due to the ownership of a business interest)
- expenses, including interest, paid to generate tax-exempt income
- federal income tax
- fines and penalties incurred for violations of law, such as child labor violations, federal income tax penalties, traffic tickets, and penalties for overweight or over-length trucks.
- gift tax
- gifts to employees that are valued at more than $25
- any portion of a gift to a business contact that is valued at more than $25
- hobby losses
- interest on indebtedness incurred by a business taxpayer to purchase life insurance coverage in excess of $50,000 on the life of any its officers, employees, or other person having a financial interest in the taxpayer's trade or business
- interest on indebtedness incurred to purchase single premium life insurance contracts, or any life insurance contract under a plan of financing the purchase by withdrawing some or all of the yearly build-up in policy cash values
- job hunting expenses (for a new trade or business)
- life insurance premiums, if the business, or the business owner, is a direct or indirect beneficiary.
- lobbying expenses (appearances before legislative bodies and expenses to influence voters)
- partnership organizational expenses, unless amortization election made
- personal, living, or family expenses; however, certain interest, taxes, bad debts, medical expenses, theft or casualty losses, or charitable contributions may be deductible in whole or in part as an itemized deduction on your individual tax return
- political contributions, including tickets to political dinners
- tax penalty payments
- transfer taxes on business property