Business Income & Tax-Deductible Expenses
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A. How the
Tax Code Focuses on Profit
There are many systems of business taxation in use over the world. In much of Europe, the “value added tax,” or VAT, is the rule. The VAT taxes the incremental value added to a product at each stage of manufacturing and distribution. Another approach is to tax a business on its gross receipts, whether or not it makes a profit.
The U.S. tax code zeros in on a business’s profits: the
more you make, the more you pay. So the American entrepreneur has a strong
incentive to keep taxable profits low, while at the same time taking home as
much money and benefits as the law allows. Doing this legally has a price—you
need to learn your ABCs (and even your DEFs) about how your enterprise is
taxed. We’ll start with some basic tax rules governing how expenses are
deducted, to give you the greatest tax benefit.
Congress says just about any expense to produce income can
be deducted from a business’s receipts. But to get the deduction, you must
follow the Internal Revenue Code (IRC).
Here’s a very simple illustration of how taxable profits
are determined.
Example: Sam and Jeannie own Smiths’ Computer
Sales and Service as a sole proprietorship. Because their business produces a
good profit, they are in the highest federal tax bracket (38.6% in 2002). Here
is how the business determines its taxable profit.
Gross Sales
(receipts from sale of computers) $2,500,000
Less: Cost of Goods Sold
(what was paid for the computers
by the Smiths) –
1,900,000
Gross Profit
(before operating expenses) = 600,000
Less: Deductible Business Expenses – 300,000
Net Profit (Taxable to Smiths) = $ 300,000
The $300,000 net profit is
subject to income tax. How much tax the Smiths will actually owe on their business
income depends on other factors, including: their other income, losses on any
investments, personal deductions
such as for home mortgage interest and,
most important, how much they can take out of the business in fringe benefits.
Federal Excise Taxes:
Some
businesses face federal “excise taxes.” For instance, an interstate trucking
company may have to pay a federal excise tax on fuels or on each truck. Excise
taxes affect few small businesses, so we won’t go into detail. Businesses most
likely to be subject to excise taxes are in transportation or manufacturing. If
you are curious, see IRC §§ 4041 to 5763 to find out whether or not
you are affected. Otherwise, you may not discover this special tax until it is
too late—when you receive a huge bill for delinquent excise taxes.
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B. What Is Earned Income?
Before getting into
business deductions, let’s make sure we all understand what the tax code means
by the term “income.” With a few exclusions discussed below, the tax law
doesn’t care whether you get it from your business, from wages paid by someone
else’s business or from an investment: it is taxable to you as an individual.
Actually, the better question for small
business tax understanding is, “What is gross income?” The tax code
(IRC § 61) talks in terms of gross income, so we will, too. It reads:
“Except as otherwise provided … gross income means all income from whatever
source derived.” You can’t get much broader than that, can you?
Goods and services. Income, for tax purposes, doesn’t mean just cash; it can take
many forms. Goods, property or services received have all been held to be
within the definition of income.
If you barter (exchange goods or services for
the same), the fair market value of the item or service you received should be included in your tax reported income. I
know—a lot of bartering goes on, and the IRS
isn’t any the wiser, but getting away with it doesn’t make it right.
Anything of value your business (or you
individually) receives is income, unless it specifically falls within the
exclusions discussed below.
Constructive income. Income includes anything you have the right to put your hands on
but don’t for some reason. The legal doctrine of “constructive receipt” says
that as soon as money or property is available to you, or is credited to your
account, it becomes income—whether you grab it or not. For instance, you can’t
get a check for your services in November 2001 and hold it for deposit until 2002
without being taxed on it in 2001, the year received.
Illegal income. Note that IRC § 61 is morally neutral; it doesn’t
distinguish between illegal and legal income. If you earn a living as a hit man
for the mob, you still are earning income, and had better declare it on your
tax return. Al Capone wasn’t sent to prison for murder, bootlegging or
racketeering; he was convicted of tax evasion for not reporting the fruits of
his labors to the IRS. You don’t have
to disclose the sources of your income in some cases, however.
Worldwide income. Americans are taxed on their worldwide income; no matter where
earned it is still income taxable in the U.S. There is one exception: if you
earn it and reside outside the United States for most of the year, some or all
of your foreign income may be excludable. This exception is beyond the scope of
this book. See IRS Publication 54, Tax Guide for U.S. Citizens and Resident
Aliens Abroad. You may also be entitled
to a credit toward your U.S. income tax bill if you paid foreign income taxes.
What isn’t income: exclusions. Some kinds of income fall into the “except as otherwise provided”
exception of IRC § 61. For instance, the tax code specifically
excludes gifts and inheritances from taxable income. There is no dollar
limitation on how much you can get by these means without tax to you. (Sorry,
the $10 million that is being dropped off by the Prize Patrol from Publisher’s
Clearinghouse is not legally a gift and is taxable.) Thankfully, many so-called
fringe benefits provided by businesses to owners and employees are specifically
excluded from income. Specific exclusions from income granted by Congress are
found in IRC §§ 101 to 150.
Return of capital. Of great importance to owners and investors in businesses is that
the return of a capital investment is not taxable income. In other words, to
the extent that you sell a business or an asset and get back your money
exchanged for the asset, you haven’t earned any taxable income. Only the
profit, if any, is taxed.
Example: Toni invests $1,000 in the stock of Ronaldo’s Rubber Fashions,
a small business corporation, and later sells her stock for $1,500. Only $500
is considered income for tax purposes; the other $1,000 is a return of capital
to Toni.
Tax-free withdrawals. If you borrow
against an asset, whether it belongs to your business or to you personally, the
loan proceeds are not income. This is a valuable tool for taking money
tax-free out of an unincorporated business that holds an appreciated asset,
such as real estate.
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C. What Is
Tax-Deductible in Business?
The tax code allows
you to deduct costs of doing business from your gross income. What you are left
with is your net business profit. This is the amount that gets taxed.
So knowing how to maximize your deductible
business expenses lowers your taxable profit. To boot, you may enjoy a personal
benefit from a business expenditure—a nice car to drive, a combination business
trip/vacation and a retirement savings plan —if you follow the myriad of tax
rules. The balance of this chapter deals with the best ways to get the biggest
business expense deduction bang for your buck.
1.
Business
Operating Expenses
Internal Revenue
Code Section 162 is the cornerstone for determining the tax-deductibility of
every business expenditure. It is fairly lengthy, but the first hundred or so
words are the key:
“Internal Revenue Code § 162. ‘Trade or
business expenses.’
“(a) In general. There shall be allowed as a deduction
all the ordinary and necessary expenses paid or incurred during the taxable
year in carrying on any trade or business, including
“(1) a reasonable allowance for salaries or
other compensation for personal services actually rendered;
“(2) traveling expenses (including amounts expended
for meals and lodging other than amounts which are lavish or extravagant under
the circumstances) while away from home in the pursuit of a trade or business;
and
“(3) rentals or other payments required to be
made as a condition to the continued use or possession, for purposes of the
trade or business, of property to which the taxpayer has not taken or is not
taking title or in which he has no equity.”
Section 162 goes on—and on—but the rest of it deals
with specific items that can’t be deducted. Those with relevance to small
businesses are covered later. Other code sections contain specific rules for
deducting purchases of assets used in your business—machinery, cars and a
thousand other things. We’ll get to asset write-offs in the next chapter.
Right now we are focusing on the day-to-day operating expenses of a business.
In most cases, a legitimate business expense under
IRC § 162 is obvious. In some cases, such as outlays for travel, the
IRS provides specific instructions for determining whether or not an expense is
“ordinary and necessary.” This is often done through various IRS publications
(“pubs”) and “regulations” mentioned above and noted throughout this book.
Like the rest of the tax code,
IRC § 162 is far from crystal clear. Starting with the meaning of “ordinary
and necessary,” we suspect that things could go wrong for us. The tax code
doesn’t define either “ordinary” or “necessary.” Instead, myriads of federal
courts have tried to figure out what Congress intended and apply it to a
particular set of facts. “Ordinary” has been held by courts to mean “normal,
common and accepted under the circumstances by the business community.”
“Necessary” means “appropriate and helpful.” Taken together, the legal
consensus is that “ordinary and necessary” refers to the purpose for which an
expense is made. For instance, renting office space is ordinary and necessary
for many business folks, but it is neither unless it is actually used in
running an enterprise for profit.
Given these broad legal guidelines, it is not surprising
that some folks have tried to push the envelope on “ordinary and necessary”
business expenses, and the IRS has pushed back. Sometimes a compromise is
reached, and sometimes the issue is thrown into a court’s lap.
Example: Mr. Henry, an accountant, deducted his yacht expenses,
contending that because the boat flew a pennant with the numbers “1040,” it
brought him professional recognition and clients. The matter ended up before the
Tax Court. The court ruled that the yacht wasn’t a normal business expense for
a tax pro, and so it wasn’t “ordinary” or “necessary.” In short, the yacht
expense was personal and thus nondeductible. (Henry v. CIR, 36 TC 879 (1961).)
The laugh test. Tax pros frequently rely on the “laugh test”: Can you list an expense
without laughing about putting one over on the IRS? In the example above, the
Tax Court laughed the accountant and his yacht out of court.
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D. Current or Capitalized Expense?
Tax rules cover not
only what expenses can be deducted but also when—what year—they can be
deducted. Some types of expenditures are deductible in the year they are
incurred, but others must be taken over a number of future years. The first category
is called “current” expenses, and the second “capitalized” expenditures. You
need to know the difference between the two, and the tax rules for each type of
expenditure. I’ll try to make it easy on you, but there are some gray areas.
“Current expenses” are everyday costs of
keeping your business going, such as the rent and electricity bills. Rules for
deducting current expenses are fairly straightforward; you subtract the
amounts spent from your business’s gross income in the year the expenses were
incurred.
Expenditures are those expected to generate “capitalized”
revenue in future years. They become assets of the business. As capital assets
are used, their cost is “matched” to the business revenue they help earn. This,
theoretically, allows the business to more clearly account for its
profitability from year to year.
However, it is not always clear what is a
current expense and what is a capital one. Normal repair costs, such as fixing
a broken copy machine or a door, are obviously current expenses and so can be
deducted in the year incurred. On the other hand, the tax code says that the
cost of making improvements to a business asset must be capitalized if the
enhancement:
• adds to its value, or
• appreciably lengthens the time you can use it,
or
• adapts it to a different use.
“Improvements” usually refers to real
estate—for example, putting in new electrical wiring, plumbing and lighting—but
the capitalization rule also applies to rebuilding business equipment.
Example: Gunther uses a specialized die-stamping machine in his metal
fabrication shop. After 15 years of constant use, the machine is on its last
legs. His average yearly maintenance expenses on the machine have been $10,000,
which Gunther has properly deducted as repair expenses. In 2001, Gunther is
faced with either thoroughly rehabilitating the machine at a cost of $80,000,
or buying a new one for $175,000. He goes for the rebuilding. The $80,000 expense
must be capitalized—that is, it can’t be taken all in 2001 when the die stamper
is rebuilt. The tax code says that metal-fabricating machinery must be
deducted over five years.
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E. Special
Deduction Rules
Some common and
not-so-common business expenses have special rules that govern how they must
be tax-deducted.
1.
Vehicle
Expenses
Motor vehicle
expenses are frequently one of the greatest small business tax-deductible
items. Fine-print tax rules for claiming car and truck expenses for your
business are tricky, but well worth mastering; they can provide a jumbo payoff
at tax time.
Records. The first thing to know is to make
sure you keep the right records to calculate your vehicle expense deduction—and
to back you up if you are ever audited. It is a good idea to keep a trip and
mileage log.
Business/personal use allocation. Keep in mind
that if your automobile is used for both business and pleasure, only the
business portion produces a tax deduction. So you must track the use of a
dual-purpose vehicle and allocate business/personal use. The proper allocation
will come from a year-end analysis of your records to come up with the percentage
of each use, such as “62% business, 38% personal.”
If you own or lease just one car or truck, no
IRS auditor will allow you to claim that 100% of its use is business-related.
(I have seen folks get away with as much as 90%, though.) Of course, if you
have both business and personal vehicles, and the business one is obviously
dedicated to a business use (a minivan with your logo painted on the side), it
isn’t necessary to do any allocation to claim 100% business use.
Two methods to claim vehicle expense
deductions. The tax code gives you a choice of two ways to calculate and
deduct business vehicle expenses: the standard mileage and actual expense
methods. With some qualifications explained below, you may switch between the
two methods each year and choose the one that gives you the largest tax benefit.
As a rule, if you use a newer car primarily for business, the actual expense
method provides a larger deduction. But the mileage method works better for
some folks and requires much less recordkeeping.
a. Standard Mileage Method for Deducting Vehicle Expenses
The simplest way for
writing off business vehicle expenses is called the mileage or standard mileage
rate method. You just total up the number of business miles driven over the
year and multiply by 34.5¢ (2001 tax code allowed rate). Commuting miles
(getting to and from your business location) are nondeductible personal miles,
but if you’re home-based, generally all trips from home for a job are
considered “business.” You can elect to use the mileage method whether you own
or lease your vehicle.
Not everyone can choose the mileage method. If
any of the following conditions apply, you must use the “actual expense” method
(discussed next):
• You used more than one vehicle simultaneously
for business.
• You previously used the actual expense method
on this same vehicle and claimed an accelerated depreciation method.
• You ever claimed IRC § 179 to write
off part of the vehicle’s purchase price.
If you choose the mileage method, you cannot
also deduct your operating expenses—gas, repairs, license tags and
insurance—but you can deduct parking fees, tolls and any state and local
property taxes on the car or truck.
Example: In 2002, Morris drove 10,000 business miles in his practice of
veterinary medicine. He also spent $700 in bridge and highway tolls and for
parking garages. Morris’s 2002 vehicle expense deduction is $3,650 (36.5¢ x
10,000) + $700 = $4,350.
Primary disadvantage of mileage method. If the
mileage method for claiming auto expenses is chosen, you can’t take a
depreciation deduction on the vehicle—which could be substantial with newer
cars. But again, the more miles you drive the more the mileage method may be
to your advantage. It pays to figure it both ways, as we shall see.
b.
Actual Expense Method for Deducting
Vehicle Expenses
The mileage method
described above works well for some, but it doesn’t cover the full cost of owning
and operating most newer cars. If your auto costs more than $15,800, it is
usually better to use the actual expense method to get the depreciation
deduction. Simply total up your car operating expenses—gas, repairs, insurance
and so on—and then add the depreciation deduction allowed in the tax code.
Example: Sam buys a Plymouth minivan in 2001 for $25,000 and uses it 100%
for his business. He drives the van 10,000 miles the first year. The tax code
allows a maximum of $3,060 for depreciation in the first year of ownership (2001).
Sam’s actual operating expenses for 2001 for gas, maintenance and insurance
total $2,600, plus $700 for parking and tolls. Sam can deduct a total of $6,360
for car expenses in 2001, including depreciation.
How to Claim Expenses for Autos
A
business claiming expenses for car use must file IRS Form 4562, Depreciation
and Amortization, with its tax return. This form requires a breakdown listing the
business, personal and commuting miles driven during the year. Even if you
don’t use the mileage method, you still must use this form and report the
number of miles driven for business.
2.
Costs
of Going Into Business
All costs of getting
a business started before you actually commence operations are not current expenses
but are capital items—including advertising, travel, office supplies,
utilities, repairs and employee wages. (IRC § 195.) This can be a bit
of a shock, since these are the costs that can be immediately deducted as
expenses once you are open for business. Under the tax code, these start-up
expenses must be deducted ratably over the first 60 months you are in business.
Technically, the tax code calls these deductions “amortization” of expenses.
(For sole proprietors, partners and limited liability company members, these deductions
are claimed on IRS Form 4562, Depreciation and Amortization.)
Example: Bill and Betty set up Management Consulting Partners (MCP).
During the first three months of 2001, they locate and fix up office space
(with the help of a handyman) and have brochures printed and mailed to
prospective clients. MCP spends a total of $6,000, and on April 1st, it opens
for business. Tax result: all of the pre-April costs are capital expenditures
and as such are deductible at the rate of $100 per month over the first 60
months MCP is in business. Therefore, in 2001, $900 can be deducted for the
nine months the business was open, $1,200 in 2002, and so on until 60 months
elapse. Expenses incurred after the business is in operation—April’s rent and
most other recurring monthly costs—are 100% deductible in 2001.
You can work around this
limitation. If it would tax benefit you to deduct start-up costs in
the first year rather than pro rata over five years, you might legally be able
to:
• delay paying pre-opening costs until you start
serving customers. (Whether or not your suppliers and workers will allow you
this much time to pay is another matter.) The IRS, if you are audited, may
challenge this tactic, however.
• do a trivial amount of business before you are
officially open. That will probably be enough to get you by an IRS audit. Make
a $75 sale to a friend or give a few people a bargain they can’t resist, just
to get some activity on the books.
Before rushing to get the start-up cost deduction all in the first year, make sure this really helps your tax situation. If, like many businesses, you will suffer low gross receipts or even losses the first few years of operation, you might be better off taking this deduction over 60 months.
Costs of not going into business. What happens if, after incurring start-up expenses, you back out
and never go into operation? Your costs may or may not be deductible, depending
on the tax rules you fall under. The tax code (IRC § 195) divides
expenses of trying, but failing, to establish a business into two categories:
• Costs of investigating whether to start a
business. Any expenses for a general search or preliminary investigation are
not deductible.
• Costs of attempting to acquire or start a specific
business. These are classified as “investment” expenses. All investment
expenses are itemized deductions on Schedule A of your individual income tax
return. As such, they don’t provide as much tax benefit as do “start-up” type
expenses. They are not considered start-up expenses because you never went into
any business.
3.
Legal
and Other Professional Fees
Professional fees
for attorneys, tax pros or consultants generally can be deducted in the year
incurred, as long as you actually go into business. For instance, fees for
forming the business—drawing up a partnership agreement or reviewing license
requirements—are immediately deductible. However, when professional fees
clearly relate to future years, they must be deducted over the life of the
benefit. Some fees, however, fall into a gray area, and you can choose between
deducting them all in the first year or spreading them over future years.
Example: Carlos and Teresa’s attorney helps them negotiate and prepare
a five-year lease for their restaurant. In this case, the lawyer’s fees may be
deducted either in the current year or in equal amounts over the lease’s
60-month period. Carlos and Teresa should figure out which method gives them
the best tax benefit. Taking the expense all in the first year of operation may
not be a good idea if they won’t have sufficient income to offset it.
Tax assistance and tax return preparation fees
are deductible. But again, it can get sticky. Folks usually want tax advice
covering both their business and individual taxes, which in most cases are intertwined.
For instance, you might ask a tax pro how to minimize taxes on income from all sources—your
sole proprietorship, stock and real estate investments and your spouse’s
income. Her fee qualifies as a business tax deduction in proportion to the
business advice given or time spent to prepare the business tax schedule or
return. The remaining portion, for tax advice on investments and spouse’s
income, can be deducted (but not as a business expense—as a personal itemized
deduction on Schedule A of your return along with fees for tax preparation).
Separate bills for
business and personal expenses. If you see a lawyer
or a tax pro, ask that the bill clearly show the extent the work was related to
your business. The IRS rarely questions the apportionment used, so ask the
advisor to be liberal in putting as much of the expense as possible to the business
side.
4.
Research
and Experimentation Expenditures
Certain enterprises
are entitled to a research tax credit equal to 20% of these expenses. A
“credit” is more valuable than a deduction, as it comes straight off your tax
bill. Very few businesses qualify, however. Check with a tax pro to see
whether or not you can use this credit (chances are you won’t qualify), and
whether or not it has been extended by Congress to the current year. (Form 6765 and Form 3800 are used to claim
this credit.)
5.
Business
Bad Debts
If you are in
business long enough, you will eventually be stiffed by a deadbeat. The
resulting bad debt may or may not be a deductible expense. Read on.
(IRC § 166, Reg. 1.166.)
If your operation offers services—consulting,
medical, legal and so on—you cannot deduct an unpaid bill as a bad debt. No tax deduction is allowed for time you devoted to the client
or customer who doesn’t pay. The tax code rationale is that if you could
deduct the value of unpaid services, it would be too easy to inflate your bills
and claim large bad debt deductions—and too hard for the IRS to catch you.
If your business provides goods, however, you
can deduct the costs of any goods sold, but not paid for, as an ordinary
business expense. You cannot deduct any lost profits you would have collected
from the sale.
The same is true if you actually lose dollars.
For instance, say you made a loan to a customer or client and didn’t get paid
back. To get the deduction, there must have been a business—not personal—reason
for the loan. Also, you must have taken reasonable steps to collect the
debt—such as making a written demand for payment, going to court or turning the
debt over to a collection agency.
Example: In 2000, Ralph and Rhonda’s incorporated print shop made a
$2,000 loan to Susan, a friend and good customer, to keep her florist business
afloat. Despite this help, Susan went into bankruptcy in 2001 before making any
repayment. Result: As long as Ralph and Rhonda’s corporation made the loan to
protect their business relationship—and not just to help a friend—the bad debt
is deductible for the corporation in 2001.
Nonbusiness bad debts. There are different tax rules for “nonbusiness” bad debts—ones
that don’t qualify as business expenses. A bad debt in your personal life can
still produce a tax benefit, but under the much more restrictive short-term
capital loss rules for individuals. Generally this means that a bad debt can be
claimed only to offset any capital gains—plus up to another $3,000 in ordinary
income. To claim a nonbusiness bad debt deduction, file Schedule D, Capital
Gains and Losses, with your tax return. A loan to Uncle Festus falls into this
category, but not if it was really a gift to get him into alcohol rehab and you
never expected to get the money back. To bulletproof the deduction, get a
signed promissory note from Festus and show you made some written efforts to
try to collect on it. Expect an auditor to be suspicious if a relative is the
deadbeat you are trying to wangle into a tax deduction.
A business or nonbusiness bad
debt claimed on a tax return will likely increase your audit chances. Attach a
statement to the return referring to the bad debt with the date it became due,
the name and address of the debtor and your reason for determining it was
worthless—the guy skipped town, died, declared bankruptcy or whatever. Of
course, there is no free lunch; if in 2001 you collect the debt previously
deducted as worthless, you must then report it as income in 2001.
Note: If your business
uses the accrual accounting method, you have an alternative way to deduct bad
debts, which may be more advantageous than described above. This is too
technical to get into here, so see your tax pro or IRS Publication 535,
Business Expenses, for details.
6.
Promotion
Expenses and Business Entertaining
If you pick up the
tab for entertaining present or prospective customers, clients or employees,
the cost is partially—not wholly—deductible.
You may deduct 50% of a business entertainment
expense if it satisfies one of two tax code tests. The expense must either be:
• “directly related” to the business. Business
must actually be discussed during the entertainment. For example, a catered
meeting at your office would qualify, or
• “associated with” the business. The
entertainment must take place prior to or immediately after a business
discussion. This is more common—no business has to be discussed while having
fun—for example, if your meeting is followed by an evening out at a restaurant,
play or sporting event.
The costs of transportation to the
entertainment event are fully deductible, and so aren’t subject to the 50%
limit.
Corporate entertainment expenses. If your enterprise is a C corporation, and you entertain
customers or clients, you can either personally pay the expenses and claim
reimbursement, or have the corporation pay the expenses directly. Direct
corporate payment is better—for instance, using a credit card and letting the
corporation pay the bill.
If you are not reimbursed by the corporation,
you must claim the expenses as deductions for “unreimbursed employee expenses”
on your individual tax return, which is less advantageous tax-wise. Also,
claiming this type of expense increases the chances of an audit of your
personal return.
Employee parties. Holiday parties and picnics for employees and their families are
Congressionally recognized morale builders. These affairs are not subject to
the regular entertainment rule and so are 100% deductible. Don’t overdo it,
though. To be fully deductible, employee get-togethers must be infrequent, and
everyone at work must be invited. No business need be discussed.
Home entertaining. You can get a deduction for home entertaining if you follow the
rules. To qualify, guests must either be employees or have a business connection—that
is, they must be a present or potential customer or client. If family or
social friends are also present, their pro-rata share of party costs is not
deductible. You are on the honor system here. If audited, it will help your
cause to show you gave other (purely social) parties you did not claim as
business expenses. For guests other than employees, keep notes showing who was
present and the nature of the business discussed before, during or after the
get-together.
Business gifts. You may make deductible gifts to clients and customers as long as
the value does not exceed $25 per person per year. You can also deduct the cost
of wrapping, mailing or even engraving the gift, so the real limit is slightly
higher than $25. And items costing less than $4 on which your business name is
imprinted aren’t counted against the $25 limit.
Keep good records of
business entertainment.
If you have a business party, keep a written guest list, along with your
explanation of the business connection or general nature of business discussed.
This should satisfy most IRS auditors, unless the amount spent was outrageous.
I have never heard of an auditor contacting guests to see whether or not
business was really discussed or there was a business tie-in.
The following table may help you understand
the various tax code rules on entertainment expense deductions.
When Are Entertainment
Expenses Deductible?
General
Rule:
You can deduct expenses to entertain
a client, customer or employee if the expenses meet the “directly related” test
or the “associated” test.
Definitions:
• Entertainment includes any activity
generally considered to provide amusement or recreation, and includes meals
provided to a customer or client.
• The type of expense must be common and accepted
in your field of business, trade or profession.
• The expense must be helpful and appropriate,
although not necessarily indispensable, for your business.
Two
tests:
“Directly related“ test
• Entertainment took place in a clear business
setting such as your business premises, or if it didn’t, the
• Main purpose of entertainment was the active
conduct of business, and
a. You did engage in business with the person
during the entertainment period (such as, you talked business during lunch), and
b. You had more than a general expectation of
getting income or some other specific business benefit (such as, it was a
long-time customer). However, you don’t have to prove that income actually
resulted from the entertainment.
“Associated“ test
• Entertainment is associated with your trade
or business, and
• Entertainment directly precedes or follows a
substantial business discussion.
Other rules:
• You can deduct expenses only to the extent
that they are not lavish or extravagant under the circumstances.
• You generally can deduct only 50% of your
business entertainment expenses.
• If your client brings along a spouse, you
can bring yours, too, and deduct the cost as an entertainment expense.
7.
Advertising
and Promotion
The cost of ordinary
advertising for your goods or services—business cards, Yellow Page ads and so
on—is deductible as a current expense.
Promotional costs that create business
goodwill —for example, sponsoring a Peewee football team —are also deductible
as long as there is a clear connection between the sponsorship and your
business. For example, naming the team the “Southwest Auto Parts Blues” or
listing the business name in the program is evidence of the promotion effort. A
contest prize given to a customer qualifies as a promotional expense, but not
if an employee wins it.
Any cost that is primarily personal is not
deductible. For example, you can’t deduct the cost of inviting customers or
clients to your son’s wedding. Also not deductible are costs of lobbying a
politico (with a few limited exceptions).
The cost of advertising signs, if they have a
useful life of over one year, must be capitalized, and depreciation deductions
taken over seven years.
- Taxes
Various kinds of
taxes incurred in operating your business are generally deductible. How and
when to deduct taxes in your business depends on the type of tax.
Sales tax on items purchased for your day-to-day operation is deductible as part of the cost of the items. It is not deducted separately as taxes. On the other hand, sales tax (or federal luxury tax) on a business asset—such as a truck bought for your business—must be added to the vehicle’s cost basis. This means the sales tax is not totally deductible all in the year the truck was purchased.
Sales taxes that you collect as a merchant and
pay over to the state are not deductible unless you included them in your
business’s gross receipts.
Excise and fuel taxes paid by qualifying
businesses are deductible as separately stated tax expenses.
Employment taxes (FICA) paid by your business
are partially deductible. The employer’s one-half share is deductible as a
business expense.
Self-employment (SE) tax isn’t a business expense.
However, the owner can deduct one-half of the SE tax on the front page of his
or her Form 1040 tax return.
Federal income tax paid on your business’s income
is never deductible.
State income tax can be deducted on your personal
federal tax return as an itemized deduction on Schedule A, not as a business
expense.
Real estate tax on business-used property is deductible,
along with any special local property assessments. However, if the assessment
is for improvements (for example, a sewer or sidewalk), it is not immediately
deductible; instead, the cost is added to the basis of the property and
deducted (amortized) over a period of years. Real estate tax
for nonbusiness property, such as your home, is deductible as an itemized
deduction on Schedule A of your personal tax return.
Penalties and fines paid to the IRS and any
other governmental agencies are never tax-deductible, because this is deemed
to be against public policy.
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F. How and Where Deductions Are Claimed
Although the tax
deductibility rules for business expenses are consistent, how you claim the
expenses on your tax return often depends on your particular entity form. The
basics of expense tax reporting for business entities are as follows.
Sole proprietors (including independent contractors)
and statutory employees report business expenses on Schedule C of their
individual income tax returns (Form 1040). Always keep in mind that in the eyes
of the tax code, a sole proprietor and his business are one and the same.
S corporations (Form 1120S), partnerships and
limited liability companies (Form 1065) file their own returns showing expense
deductions. In turn, these entities issue Form K-1s to their owners showing how
much profit or loss is reportable by each individual. This amount is reported
on Schedule E of their Form 1040s. So, with a few exceptions, an S corporation
shareholder, partner or limited liability owner’s tax returns won’t list any of
their business’s expenses.
Non-owner employees of businesses who incur
out-of-pocket business expenses which are not reimbursed to them can also
deduct them, but only under the restrictive “unreimbursed employee expense”
rules on Schedule A of their Form 1040s. For this reason, a business should
always either fully reimburse its employees for their expenses or should pay
those expenses directly.
Some things, such as business charitable
contributions and moving expenses, are not technically business expenses, but
must be claimed on Schedule A of the business owner’s personal tax returns.
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© 1999-2001 Nolo.com All Rights Reserved
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G. General Business Credit
The general business
credit is a dollar-for-dollar credit against income tax, which can be taken by
a relatively few small business owners. Since so few qualify, I won’t go into
much detail, but will just alert you to the possibilities. If anything below
sounds like it might affect you, check it out with the IRS or your tax pro.
A taxpayer’s general business credit is the
sum of the following individual credits:
• investment credit, which is composed of the
rehabilitation property, energy and reforestation credits
• welfare-to-work credit for wages paid to
long-term family assistance recipients
• low income housing credit (Form 8586)
• alcohol fuels credit
• research
• disabled access
• renewable resources electricity production
• American Indian employment
• contributions to certain community development
corporations, and
• work opportunity credit (Form 5884).
There are also a few other really esoteric
items, not mentioned above.
To claim any credits, file Form 3800, General
Business Credit, along with your annual income tax return. None of these credits
are “refundable,” meaning that they can’t be used to claim a tax refund, only
to reduce a tax liability.
Commonly Overlooked Business Expenses:
Despite the fact that
most people keep a sharp eye out for deductible expenses, it’s not uncommon to
miss a few. And some folks don’t list a deduction because they can’t find what
category it fits into. Some overlooked routine deductions include:
• advertising giveaways and promotion
• audio- and videotapes related to business
skills
• bank service charges
• business association dues
• business gifts
• business-related magazines and books
• casual labor and tips
• casualty and theft losses
• coffee and beverage service
• commissions
• consultant fees
• credit bureau fees
• education to improve business skills
• office supplies
• online computer services related to business
• parking and meters
• petty cash funds
• postage
• promotion and publicity
• seminars and trade shows
• taxi and bus fare
• telephone calls away from the business.
Just because you didn’t get a receipt doesn’t mean you
can’t deduct the expense, so keep track of those small items and get big tax
savings. Generally, business expenses
of less than $75 do not need receipts to be claimed on a tax return.
Copyright © 1999-2001 Nolo.com All Rights Reserved
Excerpted from “Tax Savvy
for Small Business”, by Frederick W. Daily