Business Expenses Explored

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In this article, I hope to explore some of the criteria necessary for an expense to be deductible. Broadly defined in IRC 162, deductible business expenses are all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. An expense is ordinary when it is common and accepted in the taxpayer's industry. An expense is necessary when it is helpful and appropriate in the taxpayer's trade or business.

Personal vs. Business
Personal expenses are not deductible. That said, expenses that have both personal and business components may be split between the two categories. As an example, a taxpayer may purchase envelopes that are used 70% in their business and 30% to send letters to relatives. 70% of the expense would be deductible in this example. Another common mixed use item for taxpayers is their home. To qualify to claim expenses for the business use of your home, a taxpayer must pass the following tests:

1. The business part must be used exclusively and regularly for their trade or business;
2. The business part of their home must be their principal address, a place where they meet to deal with clients, or a separate structure.

The key item that might prevent a taxpayer from being able to deduct the business use of their home is the exclusivity part of the test. Typically, taxpayers with an office will fail the test due to use of the space for personal reasons. As this item is particularly scrutinized by the IRS, be sure to note that an optional safe harbor method exists for calculating the deduction.

Capital Expenses (Fixed Assets)
Certain expenses have a useful life greater over 1 year and are subject to capitalization. Examples of capitalized expenses include amounts paid to purchase a computer, amounts paid to purchase office furniture, and so on. These capitalized expenses (fixed assets) are subject to depreciation/amortization over their useful lives. Additionally, special provisions might be available depending on the tax year allowing a taxpayer to immediately expense some or all of the amount.

Meals and Entertainment
Meals and entertainment represent another area of the tax code that has been under increased scrutiny by the IRS. When the expense is incurred in connection with travel or to entertain a potential client or business partner, the deduction is limited to 50%. Exceptions exist, however, when the meal is treated as compensation, the taxpayer resells the product, or the meal is provided to the general public to promote goodwill. Another exception exists if the taxpayer is providing meals to employees at their place of business for their convenience. Note that meals and entertainment are subject to more stringent reporting requirements by the IRS.

Summary
This article is designed to provide a high level introduction into the deductibility of business expenses. As the subject matter has been legislated and litigated for decades, it is challenging to address every single item that might qualify as "ordinary and necessary". In the links below, I have included references to Publication 535 (business expenses) as well as Publication 946 (depreciation) which can hopefully provide guidance to any more specific questions.

References
https://www.law.cornell.edu/uscode/text/26/162
https://www.irs.gov/pub/irs-pdf/p535.pdf
https://www.irs.gov/pub/irs-pdf/p946.pdf

Disclaimer
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.