You may be able to keep more of your earrings or avoid running afoul of the IRS by knowing what you can and cannot deduct as a business expense.
Most business deductions are not specifically listed in the Internal Revenue Code.
For example: tax law doesn’t explicitly state that you can deduct office supplies.
Some expenses are detailed in the tax code, but the general rule is contained in the first sentence of Section 162. It states you can write off “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
Basic definitions
In general, an expense is ordinary if it is considered common or customary in the particular trade or business. For instance, insurance premiums to protect a store would be an ordinary business expense in the retail industry.
A necessary expense is one that’s helpful or appropriate. For example, a car dealership may purchase an automatic defibrillator. It may not be necessary for the business operation, but it might be helpful if an employee or customer suffers a heart attack. It’s possible for an ordinary expense to be unnecessary. But to be deductible, an expense must be ordinary and necessary.
A deductible amount must also be reasonable in relation to the benefit expected. If you’re attempting to land a $3,000 deal, a $65 lunch with the potential client should be OK with the IRS, although the Tax Cuts and Jobs Act eliminated most deductions for entertainment expenses but retained a 50% deduction for business meals.
How the courts may view expenses
Not surprisingly, the IRS and courts don’t always agree with taxpayers about what is ordinary and necessary. To illustrate, here are three recent U.S. Tax Court cases in which specific taxpayer deductions were disallowed:
- A married couple owned an engineering firm. For two tax years, they claimed depreciation of $76,264 on three vehicles, but did not provide required details, including each vehicle’s ownership, cost and useful life. They claimed $34,197 in mileage deductions and provided receipts and mileage logs, but the court found they did not show related business purposes. The court also found the mileage claimed included commuting costs, which can’t be written off. The court disallowed these deductions and assessed taxes and penalties. (TC Memo 2023-39.)
- The court ruled that a married couple was not entitled to business tax deductions because the husband’s consulting company failed to show that it was engaged in a trade or business. In fact, invoices produced by the consulting company predated its incorporation. And the court ruled that even if the expenses were legitimate, they were not properly substantiated. (TC Memo 2023-80.)
- A physician specializing in gene therapy deducted legal expenses of $360,295 for two years on Schedule C of his joint tax returns. The court found that most of the legal fees were to defend the husband against personal conduct issues. The court denied the deduction for personal legal expenses but allowed a deduction of $13,000 for business-related legal expenses. (TC Memo 2023-42.)
These cases and others should show the importance of maintaining careful, detailed records. Make sure that only business costs are claimed.
Proceed with caution!
If an expense seems like it’s not normal in your industry or could be considered personal or extravagant, proceed with caution.
This column is for information only and is not intended as advice. Tax matters are often complex and mistakes can be costly in time and money. If you have questions about taking a deduction, consider contacting a tax professional.
Norm Grill, CPA, (N.Grill@GRILL1.com) is managing partner of Grill & Partners, LLC (www.GRILL1.com), certified public accountants and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, 203 254-3880.
