If you own a business, you’re always looking for ways to lower your tax payments. And while the U.S. Tax Code is a helpful reference for allowable expenses, you might be surprised to find out it does not specifically list many of the business deductions owners take for granted, let alone those that lie in the gray area for allowable expenses. Yes, the Code lists a few specifics, but most business owners look to the general rule stated in the first sentence of Section 162: “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
At first, this might seem like a phrase of infinite elasticity, but let us assure you, there are limits to how far you can stretch the rule. First, an expense must be “ordinary.” This generally means it is common or customary within your particular industry. For example, if you are a retailer, you pay rent for your space, insurance to cover your stock, workers’ compensation insurance to cover your employees, liability insurance in case a customer has a slip and fall, and other expenses that are common to virtually every retailer in your situation.
A “necessary” expense is not limited to essential spending. Rather, it is defined as spending that is helpful or appropriate. That could open the door to everything from cappuccino machines to entertain clients and Segways to cross the campus. However, you can’t deduct a helpful expense that isn’t common to your industry, because expenses must be ordinary and necessary, not ordinary or necessary.
A further test of the expense is that it must be reasonable in relation to the benefit the business derives from the expenditure. So, if you buy a Mustang GT so you can drop mail off at the post office twice a week, you’re not getting a reasonable return for your investment. However, if you need to wine and dine a client to cinch a $20,000 deal, you shouldn’t worry about claiming that deduction, though you have to be wary about the new limits on business entertainment that came in with the Tax Cuts and Jobs Act.
So, what isn’t ordinary and necessary? Here are a couple of examples from the U.S. Tax Court. In a notable case, a taxpayer engaged in a business with his brother was not allowed to deduct his private airplane expenses. The Tax Court was not convinced the expenses were ordinary and necessary to the business. This may have been because only one brother used the plane and the destinations were readily accessible by car or commercial airline. Therefore, the relative benefit of such an expense to the business was highly questionable. To make matters worse, he was claiming depreciation on the plane and did not provide sufficient evidence to substantiate that claim.
In another case, a business owner tried to claim legal fees incurred during his divorce litigation, because he was defending his interest in an LLC from claims by his wife. Those expenses may have been necessary for him to retain control of the business, but were hardly necessary to run the business. Moreover, they were not expenses that were common within his industry.
All this means you should proceed with caution, especially with regard to expenses that could be considered fun, extravagant or personal in nature. Finally, always keep detailed records of your expenses so you can justify your deductions.
For knowledgeable guidance on business deductions, contact Breon & Associates today.
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Consult Breon & Associates for knowledgeable, individualized assistance in preparation and filing. With offices in Harrisburg and North Central PA, Breon & Associates provides business, accounting and tax services throughout Pennsylvania. Call us at 1-888-516-8476 or 717-273-8626, or contact one of our offices online to schedule an appointment.
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